No one’s going to time things perfectly. But can you spot a stock market peak within, say, just a few months of its occurrence? On Wall Street, that sort of skill, more or less, translates to a superpower.
There are four key ways to spot a stock market peak:
— A yield curve inversion.
— Declining market breadth.
— Compare S&P 500 multiples to 10-year Treasury yields.
— Transportation sector isn’t part of a rally.
Here is some detail about each of these methods to spot a stock market peak.
Yield Curve Inversion
Perhaps the most famous and most frequently cited signal that a bear market could be on the way is an inverted yield curve.
The percentage yield on government-issued debt, known as Treasurys, varies depending on the duration of the debt in question. In a healthy economy, you’d expect short-term debt to yield less than long-term debt, which makes for an upward sloping graph if you’re plotting out yields over time.
[Read: What Is a Stock Market Correction?]
As investors become less sanguine though, long-term debt may actually yield less than short-term debt, indicating markets expect interest rates to fall as time goes on.
“An inverted yield often precedes a recession, but it does not mean that an inverted yield curve predicts a recession,” says KC Ma, a professor of applied investments at Stetson University. “The inversion, the long rate dropping below the short rate, suggests that the long rate is lower due to the expectation of future lack of need for long-term funding, possibly anticipating a future recession.”
Declining Market Breadth
Another prominent stock market indicator is stock market breadth, which is akin to a measure of how evenly gains are spread among different stock market gains.
Specifically, breadth is often displayed via the advance-decline line, which measures the number of stocks on the New York Stock Exchange going up minus the number going down. The higher this number is, the better.
Keep in mind, it’s possible to have advancing markets with extremely narrow breadth. Since indices like the S&P 500 and the Nasdaq composite are weighted by market capitalization, they can advance on the strength of just a few major names — Apple (ticker: AAPL), Amazon.com ( AMZN) and Alphabet ( GOOG, GOOGL), for instance — while most other stocks tread water or fall.
A steadily declining advice-decline line, or even one reaching a series of lower highs, is considered another way to spot a stock market peak relatively quickly.
[See: 6 Cheap, 2 Expensive Stock Market Sectors in 2019.]
Compare S&P 500 Multiples to 10-year Treasury Yields
“Since stocks and bonds compete for investor capital, one of the indicators that I look at is a comparison of the price-to-earnings ratio on the S&P 500 index and the implied P/E ratio on the 10-year U.S. government bond,” says Robert Johnson, a finance professor at the Heider College of Business at Creighton University in Omaha, Nebraska.
“When they are close to being equal, or when the implied P/E ratio on the 10-year Treasury is less than that on the S&P 500, it is an indication that the stock market might be overvalued,” Johnson says.
With long-term rates still fairly low from a historical perspective, this indicator isn’t close to signaling a stock market peak in early 2019. Stocks trade for just over 20 times earnings, and 10-year Treasurys yield roughly 2.7 percent, giving them what you might call a price-yield ratio of roughly 37.
“For comparison purposes, on March 1, 2000, immediately prior to the bursting of the dot-com bubble, the S&P 500 P/E was 28.3 and the implied P/E on the 10-year Treasury was 20.2,” Johnson says.
Kevin Hincks, a senior specialist in the trader group at TD Ameritrade, explains the general principle: “Higher interest rates (lower bond prices and thus higher yields) will make bonds more attractive than stocks due to more stable and guaranteed returns.”
[See: 10 of the Best Stocks to Buy for 2019.]
Transportation Sector Isn’t Part of a Rally
“The transportation sector of the market is often the leading indicator of the future economy as the actual real activity needs to be supported by transportation,” Ma says. When indicators like the Dow Jones transportation average diverge from the rest of the market, it can signal either a bullish or bearish reversal, depending on the current state of the market at large.
While some investors may believe indicators like these don’t hold much water, it’s undoubtedly true that transportation activity tends to be a strong early indicator as to where the economy — and often the market itself — is heading. It’s no wonder stock market guru Warren Buffett loves the railways.
Some words of caution. “There’s an old saying, ‘They don’t ring a bell on the market highs or lows,'” Hincks says.
Expecting to buy at the market bottom and sell at the top is completely unreasonable, which is why in a world where corporate earnings fluctuate over time, but rise over the long term, Warren Buffett‘s favorite holding period is “forever.”
Still, investors should be equipped with some basic knowledge about signals that can help them make informed, well-reasoned decisions. Many of the best historical stock market indicators actually relate to fixed income yields; in addition to those mentioned above, markets can also get spooked when 10-year Treasurys exceed 5 percent and keep rising, or when high-yield bond spreads rise. On the other hand, when margin debt peaks, it can also often closely coincide with stock market highs.
In the end, there’s no perfect predictor of when the stock market has peaked, and timing the markets is a tricky enterprise. But this much can be said with high conviction: When a number of these indicators are flashing red, investors have good reason to be cautious.
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4 Ways to Spot a Stock Market Peak originally appeared on usnews.com
