Is The Market Overbought?

Includes: DIA, QQQ, SPY
by: Steven Hansen

This week, Marc Faber (aka Dr. Doom) stated on CNBC:

I don't think the market is as overbought as it was in '87, so I don't expect a crash. But I think for the time being, the market has peaked out, and I think in the meantime, bonds, which are extremely oversold, could rebound.

No one has a crystal ball - and market dynamics do not work in completely predicable patterns. I do worry that the risk from Europe affecting the economy is not quantifiable. Looking at historical relationships, one would conclude that Europe would only be a headwind to the USA Wall Street economy (aka GDP) via lower exports, and would have little effect on Main Street. Export sector is a disproportionately small employer.

Yet, what is going on in Europe is a continuation of the unresolved global financial crisis where there is no historical precedent. Many economic forecasts use the market as a forward indicator, and though I believe this is a dangerous game to play (as the market has no vision to the effects of a European triggered financial crisis) - it seems the market has a better imperfect record of forecasting than economists.

Pundits and analysts have several good means to gauge the health of the market. My test is using published corporate profits - even though this is a lagging indicator, and you must extrapolate existing rates of growth into the future. The following are corporate profits, Dow Jones Industrial Average and GDP graphics using several index dates.

Indexed on 1987

Indexed on 1995

Indexed on 2000

Indexed on 2005

Indexed on 2010

It is the above graph indexed on 2010 that leads one to believe the market has outrun its profit potential by approximately 10% - if one wants to use profit as a gauge. On the other hand, if you view longer periods (such as indexing on 2005) - the market is just catching up to the over-correction during the Great Recession. I tend to believe the later. In all events, using any single analytical method to gauge the market is dangerous.

Whatever the case, one concern at this moment should be Europe - and its chaotic and delusional approach to banking which only ensures that southern Europe goes into financial arrest. It is contagion which is not quantifiable, and that is a real risk for a market correction. On the other hand, it also would not surprise that a European banking crisis would cause massive monetary inflows into the USA which would be a positive dynamic for the USA economy and markets.

This post does not address whether a market correction is currently overdue. There are several recent indications in the hard data that are worse than we had forecasted. Please see my instablog to read more on this subject.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.