Four signs we're close to a market top

Stock markets have been hitting fresh record highs recently - but what goes up must come down. Find out how to spot when markets are approaching the danger-zone - and how to alter your strategy.

It's one of the most disturbing sounds I've ever heard...

I was hiking on the Appalachian Trail in my native state of Virginia and heard a rapid rattle in the leaves. It was the unmistakable raspy sound of a rattlesnake's tail.

My friend and I froze. I slowly looked in the direction of the sound and saw the brown diamond pattern. A rattlesnake usually signals this way when it fears an attack and is warning that it will take action to protect itself. So while it didn't definitely mean we were going to get hurt, it did mean that we needed to be on heightened alert before proceeding. But knowing we were a safe distance from snake, we gave it a wide berth and continued along the trail.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Stock market warning signs

Well, if today's stock market could rattle, it would. Just like that snake on the trail, it's giving us some definite warning signs that this relentless one-way run up is nearing a danger zone. Should we panic? No, not necessarily. But it does mean we should be very wary of making any sudden knee-jerk moves.

So let's take a look at what warning signs are in the air - and see what actions we can take to combat the situation...

Signs the market is overextended

There's no doubt that the market is overextended to the upside. After all, it's moved almost straight up since September with no significant pullbacks. That in itself is a warning. But there are four other considerable warning signs:

Record Net Cash Inflows Into Equity Funds

When large amounts of capital flow into stock mutual funds and equity exchange-traded funds, that's a reliable sign of a pending market top. (The same is true for market bottoms and large net outflow of funds). Last week, AMG Data Services said weekly net inflows totaled $10.8 billion. That's an all-time high. This development could raise a major 'red flag' for the markets.

Volatility Index Has Hit All-Time Levels

The original CBOE Volatility Index (VXO) reached it's all-time low on January 24 this year. While the VXO (and its re-mastered offspring, the VIX) can be overused and misused, many consider the volatility index to be a prime indicator of market fear or complacency. And all-time levels certainly grab my attention. When they're at all-time low levels of fear, or high levels of market complacency (that is, investors don't seem to be worried), it could signal a potential shift in trend.

Dow Jones Industrials, Transportations, And Utilities Have All Set New Highs

When combined together, the various Dow indexes form a central part of Dow Theory, and their agreement on market direction is typically bullish. While all three heading up in tandem is usually a good sign, the fact that they all hit new highs in the same trading session for the first time since 1998 has traditionally been a sign of market topping activity.

We're In The Third-Longest Bull Market In U.S. Market History

According to the 2007 Stock Trader's Almanac, the current bull market is now the third longest we've ever seen. The only longer ones occurred in the 1920s and the 1990s. And we all know how both of those stories ended. The market is definitely showing signs of topping. But just like the rattlesnake's warning signal, this is not a time to panic. Here's what to do instead...

What this means for your investments

Even after markets become overbought, they can continue to drive upwards for long periods of time. But when they give off exceptionally important signals, it's essential that you pay attention and assume a heightened state of alertness.

So depending on what kind of investor you are, here's the plan...

If You Have Long-Term Trades That Are Performing Well: Great! Hang on to them and make sure your stops are set at the right places, in case a market pullback occurs.

If You're Considering Entering The Market For The Long-Term: Stand down, soldier. This is not a good time to jump into the market with new capital. With these many warning signals running around, prudent money will wait for a pullback or even correction before jumping in.

If You're A Shorter-Term Trader: Be wary with volatility contracting here. The market has a tendency to make 'blow-off tops' (a rapid and strong upward surge, followed by an equally quick slump back down) at junctures like this. Be on guard and wait for better volatility to boost intra-day trading in order to add some pop to your swing trades.

By D.R. Barton Jr. for the Smart Options Report,