3 Ways to Spot the Next Market Top

 If any of these technical events occurs after a major sustained market advance, traders should take note

By Sam Collins, InvestorPlace Chief Technical Analyst

New York, Feb.12, stock trade .- On Monday, stocks drifted lower in mixed trading, influenced by lower prices in Europe, a pullback in energy stocks, and anxiety over tonight’s State of the Union speech.

It was noted by The Wall Street Journal that in each of President Obama’s prior State of the Union addresses, economic anxieties have preceded the speech. And while it was emphasized that the economy is slowly improving, and “the core of the speech will focus on ways to spur the economy and job creation,” a sense of caution overhung Monday’s trading.

At the close, the Dow Jones Industrial Average was off 22 points at 13,971, the S&P 500 fell 1 point to 1,517, and the Nasdaq lost 2 points at 3,192. The NYSE traded 497 million shares and the Nasdaq crossed 347 million. Decliners outpaced advancers on both exchanges by about 1.2-to-1.

 
Click to Enlarge

While other indices, including the S&P 500 and Dow, have broken to new five-year highs, and the small-cap Russell 2000 index has broken to record highs, the Nasdaq still struggles with last September’s high at 3,196.93. Last week, it came within 4 one-hundredths of a point of breaking out only to fall back again Monday. 

Its most important internal indicator, the MACD, is in slightly bearish territory but very close to issuing a buy signal. The focus this week is on this important index that has traditionally led major rallies.

Conclusion: The stock market is very healthy, as illustrated by the variety of charts in Monday’s Daily Market Outlook that are in powerful bull market patterns. The principle chart that has yet to make a clean break higher is the Nasdaq. Although its failure to crush last September’s high is not critical, it is nonetheless a focus of many technicians. It will be a great relief to all when it finally breaks free and again leads other less-aggressive indices to new highs.

On Monday, one reader asked, “At what point do you start to get nervous and want to abandon stocks due to a bear market coming (a 20% or more loss)?” 

I somewhat glibly, but truthfully answered, “When your barber, cab driver and dentist tell you about the next ‘doubler’ it’s usually time to become defensive.” 

There is some truth in that, but there are also several more tangible indications of market tops that occur following a major sustained market advance: 

1. An increase in the number of distribution days — days that close lower by at least -0.2% on higher volume than the previous day — in at least one major index. This usually indicates the presence of institutional selling. 

2. The presence of up to five distribution days over a one-month period.

3. Topping chart patterns in major market leaders.

Tomorrow I’ll illustrate some typical patterns to look for in charts that have topped. ...