Are Stocks Overbought? These Indicators Say Yes

Includes: DIA, QQQ, SPY
by: StreetAuthority

The S&P 500 index rose another 3% last week, continuing a winning stretch that began last fall.

Since Nov. 7, the S&P has risen 22%. That works out to be a roughly 35% annualized gain. Trouble is, the rally is increasingly due to a perception by individual investors that stocks can only move in one direction: up.

In its most recent survey, the American Association of Individual Investors (AAII) noted that the percentage of investors who are currently bearish is now less than 20%. That's the lowest reading in 18 months, yet as legendary fund manager Sir John Templeton once noted, "The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell."

I've already researched one half of that maxim. Back in 2010, I noted that stocks tend to rally when that AAII survey finds few bullish investors. The logic is quite simple: When investors are in a negative mood, they have already pushed stocks down to levels that are too low to ignore. As Templeton notes, maximum optimism should be of equal concern.

Discussing the sharp gains posted in the market last week, MKM Securities' Katie Stockton noted that "short-term momentum was strong enough to lift the S&P 500 above its June levels, while generating abundant breakouts on the individual stock level. Breakouts tend to foster additional momentum," which she adds can lead to overbought conditions.

In effect, technical indicators like momentum -- not fundamental indicators like valuations and growth rates -- are ruling this market.

The Profit Disconnect
It's important to think about issues such as momentum and investor bullishness as we head into earnings season, which will replace speculation with fact. Companies in the S&P 500 are expected to boost profits 3% from the same quarter last year, though the actual figure is likely to end up closer to 4% or 5% once the numbers have been digested. In each of the past three earnings seasons, year-over-year profit growth has been 1 or 2 percentage points above early season forecasts.

Yet the real risk to stocks will be based on what companies have to say for the rest of 2013. Both a strong dollar (which mutes foreign earnings) and a fresh slowdown in key emerging market economies could easily compel companies to set a lower bar for the next two quarters.

Margin Concerns
There's an unusual stock market correlation that has developed over the past 15 years that investors should heed. In 2000 and 2007, the amount of money that investors had borrowed to buy stocks (that is, margin debt) surpassed $350 billion. In both cases, the stock market was sharply lower a year later, partially induced by forced margin selling -- and more importantly, the U.S. economy had slipped into recession by then. It's as if investors became overly aggressive with margin debt right at a time when they should have been tilting toward caution.

Well, for the third time in 15 years, margin debt has again moved above $350 billion. The figure has stayed constantly above that threshold for the whole year. (Data are only available through May, which saw a modest downtick, likely induced by "tapering" comments by the Federal Reserve on May 21, though the trend may have been reversed as those tapering comments have subsequently been walked back. The next data will be released in late July.)

The Move To Cash
Thanks to aggressive recent stock buying, many investors have come close to exhausting their sidelined cash and are "all in," as they say in poker. But having all of your chips on the table can be dangerous, especially if you carry margin debt as well.

So while your gut may tell you to stay focused on further market gains, your head should be talking you into locking in profits. Yet which stocks should you sell during this earnings season?

In market environments with less froth, you should always seek to cull the bad stocks from your portfolio and "let your winners ride." But the current environment, which has seen more than 90% of the stocks in the S&P 500 move above their 200-day moving average, means that even great stocks should be in question.

My rule of thumb: Unless a company can make a solid case for robust profit growth over the next few years, the time may be here to take profits.

I would also prioritize my portfolio, separating the low-priced stocks (in terms of price-to-earnings, price-to-book, or price-to-cash flow) from the high-priced ones. Though both types of stocks would flourish if the market moves yet higher, the lower-priced stocks at least have better downside protection if the market moves lower. Lower-priced stocks are also more likely to initiate share buyback or dividend hikes if the market comes under deeper pressure.

Risks to Consider: With U.S. trading partners in distress, this coming earnings season could take a much more somber tone. This is no time to be complacent (even though the VIX index -- the "fear gauge" -- is again below 14, signaling historically high levels of complacency).

Action to Take: Instead of focusing on the market, keep a close watch on the stocks in your portfolio. Examine the coming quarterly results (and outlooks). Merely "decent" business conditions are no longer grounds to hold any stock that has appreciated sharply in recent quarters.

Original Post

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.

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