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June Update:

Here's an update of long term indicators as well as the position of my long term trend model, which I use to make longer term decisions (over 1 year) on the market. I tend to favor shorter term trades when they are aligned with the most likely direction of the long term trend.

Shiller PE:

The Price/Earnings ratio is a method of evaluating the relative price of stocks. By dividing the price by the earnings we get a ratio that can be either compared to the ratio of other stocks, or in the case of the market as a whole, to it's relative position compared to historical levels.

The Shiller price earnings ratio was developed by Yale economist Robert Shiller and attempts to smooth the volatile raw price earnings ratio. Generally, above 20 is considered a market that is expensive and reduces the likelihood of gains going forward. Vice versa, below 10 is a market that is generally considered cheap and is the basis for long term Bull markets.

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Data courtesy of www.multpl.com/

Notes (Shiller PE):The Shiller PE currently stands at 21.1, meaning the market should be considered expensive by long term investors. This is a very long term indicator and shouldn't be used to make short term decisions. Still, it is useful for gauging the prospects for long term returns in equities.

As it currently stands, a Shiller PE ratio of > 21 most likely means that gains above the average yearly market return (approximately 7% to 8%) should not be expected. Furthermore, I would expect a greater likelihood of negative returns as well as the increased probability of some sort of longer term bear market.

The most bearish interpretation of this chart would be that equities have yet to form a long term bottom from the bubble which peaked in 2000. The market tends to be a mean reverting entity, though this is generally misunderstood. People like to misinterpret this as "the PE ratio will fall to 15." What is more likely however is that the PE ratio will fall to 10 or less thus maintaining the long-term average of about 15. The most bearish outcome however would be that the PE ratio falls far below 10 as a means of compensating for the record setting PE ratio that was achieved during the height of the bubble. It's hard to assign a probability to this event, though I would say in my opinion it is much more likely than a simply stopping at the long-term average of 15.

Lastly, I will also note that the bottom in 2009 is much less likely to be the "generational bottom" that many pundits have proclaimed it to be. This is also based on the observation of mean reversion. In my opinion it is simply unlikely that the PE ratio would achieve the all time record high during an equity bubble and simply fall to the long-term average of 15, it's more likely that this was a temporary stopping point. While this is the most bearish scenario, and it may not happen, I can still say with a high degree of confidence that at a reading of 21, stocks in general are simply not a great bargain at current prices.

S&P Dividend Yield:

The dividend yield paid out by the combined S&P 500 companies is a long term measure of sentiment among equity investors. I'm sure most have heard the saying, "a bird in the hand is worth two in the bush." This saying that lends itself well to the S&P dividend yield. When equity investors are nervous or fearful they will demand a higher dividend payout, or in other terms, more certainty. When they are feeling more confident they will be willing to accept less certainty, or a smaller certain dividend payout, in return for riskier (though less certain) capital appreciation.

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Data courtesy of www.multpl.com/

Notes (Dividend Yield): As was the case with PE ratio, the dividend yield on the S&P was pushed down to a record setting low near the peak of the equity bubble in 2000. While it has risen slightly we are still currently setting at an extremely low 2%.

The dividend yield is also a very long-term indicator and is best suited for forming a longer term opinion on likely returns going forward, rather than as an entry/exit or timing signal. In my opinion this long-term chart, like the PE ratio, also has long-term bearish implications for equity investors. While this doesn't necessarily mean a crash is imminent, I interpret this chart to mean that going forward long-term investors should severely temper their long-term expectations, and that the possibility of a bear market or negative returns has a higher probability.

If prices were to fall to the point that the dividend ratio on the S&P were at 6% or higher, then I would be much more inclined to recommend holding equities as a long-term investment. At the moment however, this is simply just not the case.

Cash Levels at Mutual Funds:

The stock market is an auction process, meaning that in order for prices to rise there needs to be buyers willing to bid at the next higher price. Therefore it makes sense to look at the supply of cash that can be used by investors to bid prices higher. Since mutual funds are among the largest owners of stocks and their cash position is public information, it makes sense to periodically review the amount of cash they have on hand.

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Courtesy of www.sentimentrade.com

Notes: Cash as a percentage of total assets is a figure that has been recorded for over 50 years, and in that time, 3.3% is one of the lowest readings ever. The effects of this could be twofold, one, mutual funds have very little cash to bid prices higher, meaning of that in the long term it will be more difficult for prices to advance. Two, since they have so little cash on hand if there is a serious decline, and mutual funds are met with large redemption orders, they will have very little cash to meet this obligation and will most likely have too aggressively sell stocks, which could in turn push prices down even further in a spiral like effect.

This figure seems to confirm the message of the previous charts, meaning that if I were to simply look at this chart as my only source of evidence, I would be very hard pressed to come up with an interpretation that is long-term bullish.

Q-Ratio and Long Term Trend Regression:

The Q-Ratio or Tobin's Q, is similar to the PE ratio in that it is a method for comparing historical values. It is computed by taking data from the Fed's beige book and determining the replacement cost of businesses. A simple example: let's say we have a business that would cost us on average $100 to replicate. If the current market prices are indicating that it would take $200 to replicate the same exact a business, we would therefore say that the current market price is expensive, and that investors must be very optimistic about the future in order to pay such a high values. If current market prices assume that it would only take $50 to replicate the business, then we could infer that this price is too cheap and that the business is undervalued. Investors are most likely very skeptical or fearful of business conditions.

The most simple explanation for regression is that it is a way of taking several data points and finding a best fit line. We can easily do this calculation with the stock market. We can take this one step further and say that if current prices move too far away from this line, either above or below, that mean reversion will likely take place. For example, if the stock market falls to one standard deviation below our linear regression line, and that is where the market has bottomed in the past, then we will have more confidence that the market will rise in the future. Vice versa, if the market has risen very far above our linear regression line, then we would have to temper our future expectations of further market gains.

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Chart courtesy of advisorperspectives.com/dshort/

Notes: The Q-Ratio currently stands at about 42% above its geometric mean, which in the past has generally meant an expensive market. Furthermore we can see the idea of mean reversion in our linear a regression chart. Every time the market falls too far below the line it tends to rebound above the line, and every time it gets too far above the line it tends to snap back like a rubber band below the line. Looking at the current chart I would say that the best interpretation of the linear regression line is that we are currently falling from the bubble peak in 2000.

It is unlikely based on past behavior of this indicator that the stock market would simply fall and touch the line and rebound. Based on the observation that the market tends to mean revert, I would guess that a further decline in the regression model as well as the Q-Ratio is likely. In layman's terms, these two indicators, as well as the previous indicators shown above, all points to a market that is expensive, making future long-term gains less likely, and raises the possibility of a bear market and several years of negative returns.

Long Term Trend Model: S&P 500 (NYSEARCA:SPY)

My long-term trend model is a momentum indicator, meaning that it assumes when prices has moved far enough away from a moving average, that a reversal has likely occurred, and that prices will continue to trend in that direction for several months if not years.

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The performance of my model portfolio was hurt the last three months because of the false sell signal that occurred several months ago. I had good confidence in this sell/bear market signal because of the indicators I've listed above. However the market had other ideas and has since rebounded. That said there are still some troubling signs in current price action.

Long Term Trend Model: NYSE

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This is a graph of the model applied to the NYSE composite. This composite index does not benefit from the meteoric rise of Apple (NASDAQ:AAPL). Furthermore, if we apply this trend model to ticker symbol VT, which is an ETF that represents all world equities, these two show what is called a "non confirmation." This means that while the S&P set a new price high and reversed the long-term a sell signal, the NYSE composite and other stock market indexes around the world did not.

Summary:

I am generally a shorter term trader but these indicators are useful for deciding what the long-term trend is. I generally like trades that happen to coincide with the direction of the long-term trend. As for regular investors who are saving for perhaps retirement, child college funds, etc. these types of indicators are more useful because with just a quick visual glance one can easily see if the market should be considered cheap or expensive compared to historical values.

The truth is that most financial advisers will simply tell you to stay invested at all times regardless of whether the market is cheap or expensive. This may be because they simply don't know, or out of self interest since their compensation is derived from the amount of assets they have under their management. Now you may say that's if one had only been looking at these charts that you would've been out of the market since the late nineties. To that I say, well what has the market done in the last 10 years? It is had large swings up and down but it hasn't improved, and while we may currently be closer to the all time highs set in 2000 and 2007, if we were to measure this in constant dollars (adjusting for inflation) you would see that the stock market has actually been consistently going down and it has only been flat or sideways if you ignore inflation. Unfortunately for most people, myself included, we do not have this luxury. So to those who say that these indicators state that one should not have been in stocks for over 10 years, my reply is simply what exactly was the benefit of being in stocks for the last 10 years?

While I am a shorter term trader, some of these skills overlap with longer term investing. One such skill is timing. There are times when is simply not beneficial to be in the market, and the key to successful investing is waiting for the times that it is beneficial to be in the market. That said, in my opinion these indicators are quite clear that if you are a long-term investor, meaning that you wish to hold stocks for several years or more, it is simply not a good time to buy,own or have a large percentage of your assets in the equity market.

Source: Even After The Recent Pullback, The Market Looks Expensive