Right Now Is One Of The Worst Times To Buy Stocks In The Past 40 Years

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 |  Includes: SPY
by: Jesse Felder

Let me preface this report by saying that if you have a proven plan for investing in the markets like the one I lay out in "FIRE Wall Street" then you can ignore everything written here. This is for those investors who have sat out of the stock market for the past few years and only now feel that it's a great time to get back in.

There are a plethora of factors that affect the future returns of the stock market but as Todd Harrison likes to say there are four main legs of the stock market table: fundamental, technical, sentiment and macro. Here I intend to make the case that all four of these factors make today's risk/reward equation for stocks very unattractive. In fact, the current environment is so unattractive from an investment standpoint that we have only seen similar situations on a handful of occasions over the past 40 years or so.

FUNDAMENTALS

Recently, James Montier of GMO revealed that the portfolios in his care are sitting 50% in cash due to the fact that his firm's 7-year asset allocation model for stocks now predicts negative returns. Warren Buffett has said, "your rate of return is determined by the price you pay," and today investors are simply paying such a high price that they are virtually guaranteeing themselves they won't make any money.

Warren has told us that he considers the stock market overvalued when the total capitalization of the stock market reaches 80% of the country's Gross National Product. The chart below is about a month old but shows that stocks, at over 100% of GNP, are clearly very highly priced - suggesting returns going forward should be meager at best.

Click to enlarge

via dshort.com

Looking at stocks relative to their earnings (red and green lines on the chart below), a more traditional measure of valuation, we see that they don't appear any more attractive than when we use the Buffett yardstick. In fact, they are overpriced by 40-60% depending on the measure and have only been this overvalued at very rare occasions over the past 100 years.

Click to enlarge

via dshort.com

Finally, when measuring stock prices to their earnings it is important to note that profit margins are unusually very high (see the chart below for historical reference). Should profit margins revert to their historical mean these valuation measures could look even more inflated than they are today.

Click to enlargeTECHNICALS

Taking a very long-term look at the S&P 500 Index we have a completed 9-13-9 DeMark Sell Signal on the monthly chart in the context of a broadening top or "megaphone" pattern (for more information about DeMark analysis see: "TD Indicators: Another Tool For The Trader's Toolbox").

Click to enlargeIn addition, a simple 3-month oscillator is currently showing this recent uptrend has entered rarefied air. We've only seen this kind of strength in stock prices 6 times over the past 30 years. As noted on the chart most of these coincided with significant peaks.

Click to enlargevia Chris Kimble

Another technical red flag for stocks is popping up in the weekly stochastics which are crossing down with a divergence (prices move higher while stochastics, at the top of the chart, cross down at a lower level):

Click to enlargeClick to enlarge

Other divergences are raising traders' eyebrows, as well. Stocks have drastically diverged from Dr. Copper (PhD in Econ.) over the past few months:

Click to enlargeStocks have also diverged from the silver/gold ratio, a good measure of risk taking:

Click to enlargeHat tip, Dave Rosenberg

Homebuilder stocks have diverged dramatically from lumber prices which have been free-falling:

Click to enlarge

Finally, John Hussman recently shared this fascinating chart which shows a rare confluence of bearish indicators. The prior occurrences should make any equity investor a bit queasy.

Click to enlargevia John Hussman

SENTIMENT

In response to this epic bull run, investors have gotten undeniably euphoric. The Market Vane bullish consensus recently reached a height it hasn't seen since June 2007, just prior to the worst bear market seen in a generation. This chart from Ned Davis Research also shows that investors have become very bullish, as well:

Click to enlargevia Forbes

Though not technically a magazine, USA Today has reflected this rampant bullishness recently by turning their logo into a bull and running headlines such as, "with stocks this hot, why worry?" and, "bull run gets solid footing."

Click to enlarge

via Business Insider

Investors aren't just talking a good game, they're also putting their money where their mouths are. Rydex reveals investors have shifted their assets heavily into bullish funds.

Click to enlarge

via dshort.com

And investors aren't just getting long, they're getting leveraged, too. Margin debt has recently hit levels only seen at major market peaks.

Click to enlargevia Short Side Of Long

What exactly is getting bought should also be of interest to prudent market participants. Todd Harrison recently wrote about "a signal that bears watching" in which he posits that a significant portion of the current demand for stocks is coming from short covering. This is supported by data showing hedge funds have all but given up on the short side recently…

Click to enlargevia Short Side Of Long

…just as investors have become intrigued with "short squeezes." The chart below shows the popularity of "short squeeze" as a search term. Interestingly enough, this is another indicator that has lined up fairly well with recent stock market peaks.

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All in all, investors have gotten so bullish they've levered their portfolios and chased hedge funds out of their short positions. If it's indeed wise to get fearful when others get greedy. Smart investors ought to be panicking right about now.

Macro

To me Macro is the trickiest one of all because it involves far more speculation than investment analysis. Still, it pays to be aware of the macro risks to the stock market even if we can never really predict what sort of catalyst will set off the next bear market. And I'll refer here to minds that are far more adept at assessing the situation than yours truly.

Mohamed El-Erian recently wrote about the four unprecedented monetary policy "experiments" currently underway at central banks around the world:

  • China, where the new leadership is managing a shift from an increasingly less-potent mercantilist growth model to one based on internal demand, while seeking to deliver it while maintaining high growth rates;
  • Europe, where governments (with the help of the European Central Bank) are trying to complete an imperfect economic union in the midst of a recession, alarmingly high unemployment (especially among the young), analytical disagreements and political tensions;
  • Japan, where the new government of Prime Minister Abe has embarked on the country's boldest post-war economic experiment, deploying the "three arrows" of highly unconventional monetary policy, aggressive fiscal expansion and (still to come) fundamental structural reforms; and
  • The United States, where the Federal Reserve is trying to deliver growth and jobs using partial and imperfect measures, and doing so without the proper support of other policy agencies that are paralyzed by Congressional dysfunction.

At the most fundamental level - and this is a critical point - the basic objective of these four experiments is to assist the economic and financial transitions by bringing to today the reality and the anticipation of tomorrow's growth.

Realizing this, markets have aggressively front run tomorrow's financial returns. Why? Because that is what markets always try to do. At times it works and at others it does not.

Kyle Bass has likened a few of these to "Potemkin Villages." The CFA Institute reports:

According to legend, Russian minister Grigory Potemkin erected fake settlements along the banks of the Dnieper River in order to fool Empress Catherine II during her visit to Crimea in 1787. According to Kyle Bass, managing director of Hayman Capital, central banks around the world today have erected their own Potemkin villages to deceive the public into thinking that the world's economic problems are solved. They aren't.

The markets, however, seem to think differently… for now. Jeff Gundlach suggests that what we have is a "bubble in central banking." He suggests that the global competitive currency debasement the banks are engaging in could exacerbate their economic problems rather than solve them.

Richard Koo has outlined exactly how this could happen in Japan. Zero Hedge reports:

The fact that the BOJ has also reversed the traditional order of things and is trying to spark an economic recovery by generating inflation has increased the possibility that higher long-term rates driven by inflation concerns will emerge sooner than higher long-term rates rooted in a recovery in the real economy.

If we refer to higher interest rates driven by an economic recovery as a "good" increase and higher rates sparked by inflation concerns as a "bad" increase, I think there is a significant possibility that the latter will emerge first in this case.

That would not only weigh heavily on the first shoots of private loan demand to arise in a long time but could also focus attention on the banks' and the government's financial health, damping the positive momentum in the economy and markets seen over the last four months.

In fact, Japanese interest rates have risen very dramatically in a very short period of time which could have unintended consequences. Bill Fleckenstein comments:

What is going on in Japan is potentially very, very dangerous not just for Japan but for world markets. And, I'm not speaking about the Nikkei. What has taken place in the Japanese JGB (Japanese government bond) is extraordinary. In the last three days, the yield has gone from 60 basis points to 86. Can you imagine what would happen in America if yields on 10-year Treasuries went from 6% to 8.6%?

There are huge derivative books in Japan where there's been tremendous amount of derivatives written assuming that rates would stay low forever. I think this could be on the verge of blowing up. This may be the start of it, this may get quiet, or it may get ugly right now. That will impact the American bond market and it will affect equities everywhere. So, it's potentially dangerous.

And volatility has risen in the Japanese stock market in reaction to just these sort of concerns. Last week it plunged 7% in one trading session, the largest decline since the tsunami, and this week saw another decline of 5% in a single day's session.

It remains to be seen if there is any fire behind this smoke and if it will have any ripples or repercussions here at home. But with valuations so high, charts flashing caution and sentiment rip-snorting bullish, I'd rather be a spectator than a participant at this point.

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.

Additional disclosure: Information in “The Felder Report” (TFR), including all the information on this website, comes from independent sources believed reliable but accuracy is not guaranteed and has not been independently verified. All material published in TFR is subject to change without notice from TFR. TFR makes no security recommendations whatsoever. All information in TFR is for educational purposes only. Opinions expressed in TFR belong solely to Jesse Felder and are subject to risks and uncertainties beyond the control of TFR. Jesse Felder is the manager of individual client investment accounts and as adviser Mr. Felder, or its associated persons, may purchase and sell securities identified, recommended and analyzed in TFR. In consideration of performance objectives of its individual client accounts, Mr. Felder may purchase and sell securities identified in TFR without notice to readers and may take a position in such securities that is inconsistent with the recommendations disclosed in TFR. Previous, successful recommendations may not be indicative of the results for all recommendations, and in fact certain recommendations have resulted in losses. Reader information is never sold, shared or otherwise distributed to third parties.