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I Am Not Sure Why This Time Should be Different

I am not sure why this time should be different. Seriously. Yes, I have read all of the internet want to be commentators that claim all market analysis is useless especially in this environment where the central banks of the world have flooded the markets with liquidity. Stocks just cannot go down and suggesting that they might is well blasphemy. But I think the data does matter and it will matter. At some point, there will be a tipping point. Are we close to that event? We are closer than we were 4 weeks ago as different data sets are consistent with price fatigue.

So let's start with investor sentiment. As we know, the "dumb money" indicator shows too many bulls. See figure 1. While most would interpret this as a bear signal, I have repeatedly stated that "it does take bulls to make a bull market". So I am comfortable with the notion of too many bulls. We should expect to see this indicator at a bullish extreme.

Figure 1. Dumb Money Indicator
Dumb Money Indicator
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However, over the last 4 weeks, the "smart money" or company insiders have become increasingly bearish. In other words, they have been selling shares at an increasing pace, and this is a bear signal. As we can see from our composite sentiment indicator, there are bullish extremes across all of our measures of investor sentiment. Once again, this doesn't necessarily mean run for the hills, but it does mean that we are closer to the end of this rally than the beginning.

Figure 2. Composite Sentiment Indicator
Composite Sentiment Indicator
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Now let's get off the sentiment kick and look at price of the SP500 relative to its earnings (5 year average). This is shown in figure 3. The indicator in the lower panel shows that this PE ratio is now approaching an extreme level of valuation as the indicator is above the upper trading band. Is this a reason for a reversal? No and in several instances over the past 20 years - like 1995, 2003, 2009 and 2010 -- such extremes have been the norm. So the question remains is this current market environment going to be more like 2009 or is the market going to rollover at this juncture?

Figure 3. SP500/ valuation
SP500 / valuation
Larger Image

A key factor in determining how prices will behave appears to be interest rates. Currently, our bond model is neutral suggesting that there are interest rate pressures (i.e., higher yields), and this should not be good for equity prices especially when you consider that stocks are overvalued and investor sentiment is overly bullish. It is this confluence of data -valuation, sentiment, and interest rates -- that suggests we are closer to the end of this rally than the beginning. This was true in 2003, 2009 and 2010. (Of note, in 1995, interest rate pressures never materialized and stocks went higher for nearly 52 weeks straight.) In each of these cases, the over bullish and over valued conditions resolved as prices dropped modestly. Of course, the dip was bought vigorously and this led to a multi-weeek (~ 8 weeks) run of speculation leading to an intermediate market top.

In summary, I don't believe this time will be different. Mounting evidence shows we are closer to the end of this rally than the beginning. The data suggests that overly bullish and overly valued conditions in the face of rising interest rate pressures should lead to tepid gains in equities. A contained sell off that relieves the over valued and overly bullish conditions is likely, and this dip in prices will be bought. This will likely result in a last gasp of speculation, higher prices and a market top sometime in the latter part of the second quarter.


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