Speculative Disaster: Market Extremely Overvalued

On February 28th, in Panic Selling Will Lead to a Sharp Bounce, we stated,

investors should be positioning themselves for a countertrend rally…We do not expect that this is the ultimate low, merely a level that will support a multi-month bounce. This reflationary bounce will be much stronger (and possibly last longer) than any other rally we have seen since October 2007. Its purpose is to put to rest the widespread fear currently in the market…This temporary bottom will support a sharp bounce into the fall.

As we will show, the stock market is currently extremely overvalued. As in 2007, we strongly advise liquidating equities. Reasons to sell two years ago included: an optimistic market, large insider selling, and low cash holdings in mutual funds. These three indicators are currently back to or above 2007 levels.

With regards to current sentiment, Investors Intelligence’s newsletter survey shows optimism is back to peak levels. Likewise, The Daily Sentiment Index (shown below) shows that traders are more optimistic now (89% are bullish) than they were at the top in early October of 2007.

Insider selling is also back to levels not seen since the top. Similarly, the cash percentage of mutual fund holdings is close to historically low levels. Mutual fund managers are not worried about investors cashing out; instead mutual funds are receiving record inflows from the investment public. When the public rushes in, it’s time to be rushing out.

These esoteric characteristics, which assisted us in 2007, are warning of a significant top. It’s as if the 2008 meltdown never happened.

"If only I'd followed CNBC's advice, I'd have a million dollars, provided I'd started with a hundred million dollars."- Jon Stewart

The Derivative Vanguard

As highlighted in Derivatives Say Bernanke Will Be Wrong, the residential mortgage index from Markit (ABX.HE), implied ‘continuing large losses’ of not only subprime but A-rated loans. With optimism eclipsing levels seen in late 2007, investors are once again blinded to risk, this time in the commercial mortgage market.

Chinese Bear Market Is a Warning Signal

After its peak in October 2007, the Shanghai Composite Index fell roughly 70% last year. Zhang, a 59-year-old laid-off autoworker complains to the AP:

I have most of my money in the market, and now I feel so sad, I want to cry…and the government said they will protect small investors, but actually our interests have been hurt most.

The Chinese market after a fierce rally has recently cratered 20% in one month. U.S. investors should heed the warning of Zhang:

I used to have money to buy a two-bedroom apartment, but now I can only afford a toilet.

What’s Next

As we explained last July,

We look forward to selling near the next bear market rally peak.

We suspect this is it. Let us state again,

Therefore we hope you are able to shrug off the need to follow the crowd, look at the evidence rationally, and protect your assets.

We have set ourselves up for another rough fall. The decline should be fast and furious.

Disclosure: No positions

Comments

[Donald Ingram:]

Paul - Excellent fore cast of things to come. I agree.
Go long GLD AND SLV. Hold the physical.

Sep 02 09:42 AM

[Larry House:]

You have laid out the worst case very thoroughly. I don't think it is sound advice to just say get totally our of equities. It doesn't have to be an either or situation. If one's investment horizon is long enough, there is no reason to bail on stocks of high-quality, strong companies that pay a decent dividend. I would certainly dump low-quality shares that have run up a lot, but high quality is still selling at a reasonable price and yield. Do you think Buffett has sold all of his holdings?

Sep 02 10:18 AM

[conceptwizard:]

This man is right on the money. I have transferred out all equity positions as of Monday.

Better to play the safety on this one.

Sep 02 10:22 AM

[Nick36:]

The latest P/E of S&P500 is 129.19.
www2.standardandpoors....

Which clearly shows an overvalued stock market. There is no way S&P 500 can stay at this high P/E ratio for a long time. Because such a high P/E ratio is equivalent to a 0.77% yield per year on your investment. And it simply doesn't make sense to sit on such a low yield in stocks for a long time. This pay doesn't compensate for risk of the stock market. Even your FDIC insured bank probably will pay you more than this on the money in your bank account.

When yield on stocks is so low, then it makes sense to go to cash. Unless you expect the earnings of companies to improve dramatically in the near future.

Sep 02 07:14 PM

[Swashbuckler:]

This author knows his sh#t cold. I mean lights out. I'd be very leery of equities at this point.

Sep 02 07:52 PM

[Mark Bern:]

When the fundamentals point to overvalued stocks and the technical indicators flash a sell signal, we had better heed the warnings. Or you could listen to MSM's Talking Heads expound about all the green shoots, stay long, and take your beating.

I'm out and have started some short positions. I think the banks are in for a tumble again as more of the truth gets out and new problems creep onto the radar such as CRE defaults.

I also like puts on SHLD at this level. I'm already in, but I think they have a long way to go. Their retail operations are lagging competition and the argument that they are a CRE investment doesn't hold much water in a deteriorating CRE environment.

Sep 02 09:09 PM

[Swashbuckler:]

Agree with you Mark. IMO, it won't be long before stocks are selling for what they're worth. The market may go sideways or fluctuate a little for a while, but the writing's on the wall, and the days are numbered for US stocks. I believe Goldman may have already loaded up on shorts, and that would be the last straw. Also, I have much respect for Reggie Middleton, as his calls have been very accurate on the bank and mortgage problems, and he is very negative on SHLD.


On Sep 02 09:09 PM Mark Bern wrote:

> When the fundamentals point to overvalued stocks and the technical
> indicators flash a sell signal, we had better heed the warnings.
> Or you could listen to MSM's Talking Heads expound about all the
> green shoots, stay long, and take your beating.
>
> I'm out and have started some short positions. I think the banks
> are in for a tumble again as more of the truth gets out and new problems
> creep onto the radar such as CRE defaults.
>
> I also like puts on SHLD at this level. I'm already in, but I think
> they have a long way to go. Their retail operations are lagging
> competition and the argument that they are a CRE investment doesn't
> hold much water in a deteriorating CRE environment.

Sep 02 09:40 PM

[untrusting ...:]

Nick,
S&P just issued their latest 2010 estimate. They estimate 2010 operating earning (not as reported earning which are always far less) for SP500 to be $73 for 2010. They assume a fair PE multiple of 16. This then implies a 2010 S&P of 73x16=1168. Of course that is probably way over optimistic nonsense. First of all PE multiples of 16 are exceedingly high for a serious recession. Schiller & Doug Short show that no past serious recessions have bottomed out until PE multiples go to less than 10. Secondly, all Schiller and Short work uses PE10 multiples (as reported earnings) which are always less than operating earnings which basically eliminate all supposedly one-time negative big charges and of course they never are one-time charges.

Thus even if one assumes the optimistic $73 operating earnings for 2010 and then uses a reasonable historical multiple like PE=10, then at best, a reasonable value for S&P in 2010 would be 730. An a great case can be made for it being even less.

There is little doubt in our view that S&P could very easily re-test the March/09 lows sometime over the coming 16 months. The large downside risk certainly far outweighs any potential limited upside potential. It is a traders (not an investors) market and those who can trade it well will do very well. Those who think they can make LT investments could well get slaughtered yet again.


On Sep 02 07:14 PM Nick36 wrote:

> The latest P/E of S&P500 is 129.19.
> www2.standardandpoors....
>
>
> Which clearly shows an overvalued stock market. There is no way S&P
> 500 can stay at this high P/E ratio for a long time. Because such
> a high P/E ratio is equivalent to a 0.77% yield per year on your
> investment. And it simply doesn't make sense to sit on such a low
> yield in stocks for a long time. This pay doesn't compensate for
> risk of the stock market. Even your FDIC insured bank probably will
> pay you more than this on the money in your bank account.
>
> When yield on stocks is so low, then it makes sense to go to cash.
> Unless you expect the earnings of companies to improve dramatically
> in the near future.

Sep 03 02:10 PM