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Editor's note: This report was initially released to the author's subscribers on 11/1/13. All references to specific dates should be read accordingly.

There is currently significant deterioration beneath the market’s surface, and we’re at a point where almost everything is overbought. Insider selling and sentiment numbers are flashing warning signs, and negative divergences are present in a plethora of indicators. Furthermore, excessive margin is being utilized. Valuation is also in the top 5% when compared over the last 100 years. More recently key names- such as IBM and Caterpillar (NYSE:CAT)- are breaking down technically, hitting 6-9 month lows while the market is at virtual all-time highs. This sub-surface deterioration is a clear sign that rough waters are ahead. It’s time to batten down the hatches and prepare for the inevitable storm!

The front cover of any major publication serves as an excellent contrarian indicator. To the left is last week’s Barron’s cover. Such bullishness is definitely negative from a contrarian’s point-of-view. We also highlighted two additional bullish financial publication covers in our September LMTR issue.

This chart gauges legal insider selling. Last spring insiders were heavy sellers before the June correction. Upon this recent advance, the ratio of sellers to buyers has again become extremely bearish.

click all images to enlarge

Stock market capitalization relative to GDP has moved back up to multi-decade highs. This suggests that investment in the market is at an extremely high level. Because the market value is so high relative to GDP, any correction will have a detrimental impact on the entire system.

Divergences Warrant Caution

The NYSE Bullish Percent (bellow) measures percentages of point-and-figure bull trends amongst NYSE constituents. This specific indicator has a major advantage over other indicators because every stock is weighted equally. It can be used effectively in a contrarian approach: A serious intermediate sell signal occurs when the indicator achieves a 70%+ reading and then moves back below 70%. This is exactly what has occurred over the last few weeks.

The NYSE Bullish Percent (highlighted in blue) has made a series of lower highs over the last four years. During the same period, the stock market has risen to a series of higher highs. This negative divergence reveals weakness beneath the indexes.

Margin debt has just hit a new all-time high, surpassing levels reached in 2007-08. In our opinion, such a high extent of leveraging is a sign of an overly enthusiastic marketplace.

The percent of stocks trading over their 200-day moving average is currently at 82.47. While this indicator has been overbought all year, it does not diminish the risk associated with such a high percentage.

Media outlets are continually bombarding the public with news of excessive cash sitting on the sidelines waiting to be invested. However, the facts entirely debunk this misguided theory. The chart to the right (especially in combination with the margin/debt situation), clearly shows that there is much less cash available to invest than the media is encouraging us to believe.

Indicators

This indicator tracks the 25 cheapest stocks in the S&P 500. When the average is below six, it is typically associated with major market bottoms. Inversely, at major market tops the average has been 16 or higher. The current reading of 16.86 is within the top percentiles of the last half century.

Sentiment

After retreating to the mid-50’s during the August pullback, NDR Crowd Sentiment has rebounded back to 70.1. The current reading is in overly optimistic territory.

The bulls have reached 52.6, which is in in the overly optimistic range. The bears fell to a 30-month low of 16.5, which is extremely bearish from a contrarian’s point-of-view. As one can see in this chart, the difference between the bulls and bears jumped to 36.1%. Since the majority polled are excessively bullish, who is left buying? This is certainly a bearish warning.

Valuation

Price/Sales is one valuation metric among many. As one can see from the chart, this ratio is now higher than it was in 2007. In fact, the current reading is at its highest level since 2000. Many other valuation measures have reached similarly alarming levels.

The S&P 500 profit margin is at a 60-year high. This is a direct result of low interest rates; a key input for capitalism. It is our opinion that this is “as good as it gets” for profit margins in the foreseeable future.

Conclusion

While it is exciting to observe equities moving higher, one must keep a firm footing on risk. We have entered an environment where valuations have become lofty and insiders are aggressively selling. Risk management should not be ignored in the face of such glaringly overvalued fundamentals and overbought technicals. We realize that the indexes have failed to provide investors with the type of scary price action that would signal alarm bells with the public. But make no mistake, the signs of an ominous storm are present. BE PREPARED!

Disclaimer

Lamensdorf Market Timing Report is a publication intended to give analytical research to the investment community. Lamensdorf Market Timing Report is not rendering investment advice based on investment portfolios and is not registered as an investment advisor in any jurisdiction. Information included in this report is derived from many sources believed to be reliable but no representation is made that it is accurate or complete, or that errors, if discovered, will be corrected. The authors of this report have not audited the financial statements of the companies discussed and do not represent that they are serving as independent public accountants with respect to them. They have not audited the statements and therefore do not express an opinion on them. The authors have also not conducted a thorough review of the financial statements as defined by standards established by the AICPA.

This report is not intended, and shall not constitute, and nothing herein should be construed as, an offer to sell or a solicitation of an offer to buy any securities referred to in this report, or a “buy” or “sell” recommendation. Rather, this research is intended to identify issues portfolio managers should be aware of for them to assess their own opinion of positive or negative potential.

Source: Market Timing Report: Rough Waters Ahead