Did Alibaba's IPO signal a top in the stock market?

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High times: Alibaba founder Jack Ma celebrates the company's gangbuster IPO at the New York Stock Exchange on Friday.

CHAPEL HILL, N.C. (MarketWatch) - Wouldn't it be ironic if this great bull market ended last Friday, on the occasion of Alibaba's record-setting IPO, the largest in history?

More than a few of the investment advisers I monitor are entertaining that possibility, especially in light of Monday's triple-digit loss in the Dow and the Nasdaq's decline of more than 1%. Alibaba dropped over 4% on its second day of trading.

Those advisers point out that history's most significant market tops have often been accompanied by high-profile events that prompt the average investor to overcome any residue of skepticism they may be harboring.

Alibaba's coming to market was certainly high profile, as its incredibly successful IPO last Friday was page-one news all weekend, featuring pictures of hundreds of cheering Chinese investors who became instant millionaires.

Yet this isn't the first time that commentators have openly speculated that the bull market had breathed its last, and at least so far they've been proven wrong. I remember that some advisers used the occasion of Facebook's May 2012 IPO to say more or less the same thing that they're now saying on the occasion of Alibaba's huge IPO.

Nevertheless, there have been a number of disturbing developments in recent months that distinguish today's market from those that prevailed at other points in this bull market. And, according to at least one market historian, these developments suggest that a market top of no small significance is imminent.

This historian is Hayes Martin, president of Market Extremes, an investment-consulting firm in New York whose research focus is major market turning points. I first heard of Martin's work from David Aronson, a former finance professor at Baruch College in New York who now runs a website, Trading Systems Synthesis and Boosting, that makes complex statistical tests available to investors.

Aronson said he doesn't 'know anyone who has studied market extremes to the depth that he [Martin] has.'

Martin's background is in medical research, where he told me the emphasis is on setting research thresholds that are high enough to avoid so-called 'false positives,' which occur when you conclude that something is present when in fact it is not. In Martin's case, that means he is willing to risk not catching a market top - a false negative - so that when he finally does declare that a market top is imminent, he will have high odds of being right.

Unfortunately, now is just such a time.

Martin is not necessarily saying that last Friday, the day of Alibaba's IPO, marked the day of the exact top, though he wouldn't necessarily be surprised. It was two months ago, in late July, when he first warned clients that a top was imminent. Though he's been surprised by stocks' resiliency, he says it's not unprecedented for the market to take several months before succumbing to his top-identifying indicators.

Martin focuses on numerous indicators, and the ways in which he combines them are proprietary. But he says they fall into three categories. The first two, listed below, serve more as necessary background conditions in Martin's work than as triggers for an imminent top. But when they're present, then the presence of the third condition, which I will summarize in a minute, takes on particularly ominous significance. These first two are:

Sentiment: Martin says market tops are accompanied by excessive levels of bullishness, and he argues that now certainly qualifies. One indicator he mentioned in this regard is the very low share of investment advisers polled by Investors Intelligence who are bearish. This percentage fell to 13.3% in early September, the lowest in nearly 30 years. Martin also draws attention to the flow of mutual fund assets into the bullish and bearish index funds managed by Rydex, which show an extremely high level of bullishness that is exceeded in Rydex's data series only by what was seen at the March 2000 market top. Valuation: The area of the market whose valuation is most troubling, according to Martin's work, is secondary stocks. His indicators, which focus on several valuation metrics such as the price-to-earnings and price-to-sales ratios, show the Russell 2000 index to be more overvalued today than at any time since it was created in 1984. In fact, Martin believes that, had the Russell 2000 index been around before 1984, you'd have to go back all the way to 1968 to find a time when secondary stocks were more overvalued than they are today. Martin adds, ominously, that 1968 was 'the grandaddy of small-cap market peaks.'

The third category of Martin's market-top-identifying indicators, which comes into play when these first two are present, focuses on market divergences. He argues that such divergences have been in place since July, and have become particularly extreme in recent sessions.

One particular data point Martin referred me to was the net percentage of weekly new highs and lows for Russell 2000 stocks (calculated by subtracting the number of 52-week lows in a given week from the number of 52-week highs, expressed as a percentage of the number of issues traded). Last week, according to Martin, even as the S&P 500 and the Dow Jones Industrial Average were hitting new all-time highs, this percentage was minus 3.2%. For the Nasdaq the comparable percentage was minus 2%.

These numbers are painting a picture of extraordinary divergence, in Martin's opinion, indicating a very unhealthy market in which the bull market is relying on the strength of a fewer and fewer number of very large-cap stocks. He says, whenever in the past you have had a new high in the large-cap indexes and net new lows among secondary stocks, 'you invariably have been at important market tops.'

Martin's best guess about how big of a decline we have in store: 13% to 18% for large-cap indexes such as the S&P 500, and 20% to 30% for secondary stocks such as those represented by the Russell 2000.

Note that, if Martin is right, the large-cap indexes are not about to suffer an official bear market, defined as a decline of at least 20%. Part of the reason he thinks a full-fledged bear market is not in the offing is the Federal Reserve, which he predicts will 'quickly step in to provide extreme liquidity to blunt the decline.'

That, in turn, is also part of the reason that Martin remains a long-term bull. If there's any good news in his work now, it's that the upcoming decline will be 'short and sweet' rather than 'long, deep and drawn out' - and that, after it's over, the bull market will quickly kick into gear again.

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