With the S&P 500 hovering near record highs, is the market over-bought? Here are three reasons to be cautious when making new equity purchases.
Shiller CAPE 10 Ratio: The current CAPE 10 ratio at 25.7 is significantly higher than its mean value of 16.5. When the ratio value moves above 20 it is time to become wary of the equity market. Even a value over 25 is not conclusive evidence the market will not move higher as investors in the late 1990s will remember. However, the probability of significant upward market movement diminishes as the CAPE 10 ratio continues to rise.
Bullish Percent Indicators: A second warning signal comes from Point and Figure graphs for hundreds of stocks that make up the important U.S. market indexes. The following table shows the Bullish Percent Index (BPI) percentages for seven major U.S. Equities markets. Markets that reflect large-cap stocks are all priced in the over-valued range or 70% and above. Those indexes are: S&P 100, S&P 500, DJIA, and DJTA. The New York Stock Exchange (NYSE) dipped below the 70% zone last April. Smaller-cap stocks are not showing the same strength as large-cap stocks, another signal the current equities market is beginning to falter.
Going back to 2013, it is apparent that these major markets can remain in the overbought zone for many months. The question is, how long can the bull market continue without a 10% to 15% correction?
Cluster Weighting Momentum Analysis: The third reason the current stock market appears to be tired is not as straight forward as the first two indicators. Cluster Weighting Momentum (CWM) requires digging deeper into the weeds of security analysis. The first move requires developing a list of ETFs that cover all major U.S. Equity asset classes, an array of bond and treasury ETFs, developed international markets, emerging markets, domestic and international REITS, international bonds, precious metals, and commodities. In other words, the global market is included in the list of ETFs [one stock, Berkshire Hathaway (NYSE:BRK.B) is included] selected to make this point.
Once the ETFs are selected, we run what is known as a Cluster Weighting Momentum analysis to see which areas of the global economy are performing best. After ranking the ETFs using three metrics, we then "cluster" the ETFs based on a correlation cutoff. A correlation cutoff of 0.5 was used in this example. We are attempting to find the best performing ETFs that have low correlations.
This list of ETFs are ranked based on the most recent three-months' performance, six-months' performance, and volatility. Percentages are assigned to each variable and a semi-variance calculation is used to determine volatility. The rankings are shown in the following table.
Check where the U.S. Equities ETFs show up on the list and you will observe they are not high on the list, particularly mid- and small-cap growth, VOT and VBK respectively. ETFs that rank high are bonds, dividend generators, REITs, Treasury, and emerging markets.
Correlation Results: ETFs from the above table are next run through a correlation analysis using 0.5 as the correlation cutoff. The cluster diagram is too large to be shown in this article, but the results are presented in the following table.
The top performing ETFs with correlations below 0.50 are: VNQ, DBC, RWX, BWX, PCY, TLT, BRK.B (Yahoo codes it BRK-B), DBA, IDV, and UNG. Not one of the "Big Seven" U.S. Equities ETFs made the list and they are: VTI, VTV, VOE, VBR, VUG, VOT, and VBK. Instead, we see three commodities (DBC, DBA, UNG), REITs (VNQ and RWX), and bonds-treasuries (BWX and TLT). BRK.B is the closest we come to the U.S. Equities market.
Will the broad U.S. Equities market move higher? That is an unknown, but the three signals listed above place a low probability we will see significant improvement over the next four to six months. It is time to be a cautious investor.
Disclosure: I am long PCY, RWX, VNQ, BWX, TLT, VWO, BRK.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I hold or have held all ETFs and stocks listed in the Rankings table.