Yes; Stocks Really Are Overvalued

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Includes: DIA, IVV, QQQ, SDS, SH, SPY, SSO, VOO, XLF, XLP, XLY
by: Daniel Goldman

Summary

Using RSI, there is an overbought signal at the daily, weekly, and monthly time scales.

According to market capitalization to GDP, stocks are again overbought.

Volume and volatility hold further clues.

This does not mean that there is an imminent threat of a crash or even a correction.

It does suggest that it is going to get increasingly difficult to eek out returns.

According to Warren Buffett, even though we keep reaching new record highs, the stock market is not in a bubble, and stocks are relatively cheap, taking into account interest rates. How true is this? Well, there are a few measures that we can use to check to see if stocks are overbought.

I honestly do not use RSI all that much, but it is a useful indicator, and I should use it more often. According to RSI analysis, the S&P 500 is absolutely overbought. It entered overbought territory around the 10th of February, and the signal exists on both the daily scale, the weekly scale, and the monthly scale. Currently (as of 3:15pm on Monday), on the value on the daily scale was above 80 and heading higher.

SPX stock chart created using stockchart.com

However, RSI is not the only method available. P/E is another method, but it is somewhat outdated. I prefer market capitalization to GDP. In a way, it is an aggregate P/E after all. Jill Mislinski did a nice analysis of this metric. Using this valuation, again stocks are overvalued. This is true if we look at the S&P 500 or the broader Wilshire 5000. In both cases, the valuation is higher than it was around 2007, and only slightly lower than it was around 2000.

Interestingly, Warren Buffett himself is saying that stocks are not overbought, even though the "Buffett" index that he has touted in the past is suggesting that they are.

Volume and Volatility

Aside from direct indicators, something else interesting showed up towards the end of Monday. First, volume appeared to be low. Volume for the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) was about 50 million, as opposed to 82 million the day before, and 62 million last Wednesday, a day that saw a tighter candlestick than we saw today. In addition, volatility spiked. VIX was up 5.84% by the end of the day, the ProShares VIX Short-Term Futures ETF (NYSEARCA:VIXY) spiked 2.2% from its low for the day.

What to Do

Short Term

Keep an eye on the political scene. It will take some time before the White House and Congress come to any sort of conclusion about protectionist policies, tax reform, and spending. Next month we will see a battle over the debt ceiling. Even if the debt ceiling, which needs to be raised by March 15, is raised without a hitch, how much it is raised will impact various future policy decisions. A failure to raise the debt ceiling would be disastrous in the short term.

There is also the issue of the Federal Reserve potentially raising interest rates. According to CNBC, the market is estimating the odds of a March rate hike at roughly 50%. While the Fed has been fairly dovish, its members also know that raising when there is a high expectation of a raise will have less effect and so might they might be willing to raise now, before the market prices in a rate hike more any more than it already has.

Between these risks, I could easily see the S&P 500 going back to a 2260 support level, and even 2180 or so in the near future.

Long Term

Of course, this does not mean that everyone should ditch their stocks and hide in some hole. While I continue to write about various risks in the market, one of the main issues is trying to actually get solid returns in a market that has already seen so much growth. Individual Trader makes a solid point about the issues of being a passive trader in this market. See "A Word Of Caution For The Passive Investor."

The days of simply throwing money into an index fund may be over. Instead, to get any kind of alpha, and really that is what this site is all about, investors will have to do a significant amount of research to find undervalued stocks. It might be a good idea to keep an eye on sector rotation as well, as Jeff Miller mentions in "Stock Exchange: How To Play Sector Rotation."

Exit Index Funds like SPY

If you are primarily invested in a broad index fund, then you have no control over stock selection. If you want to still use some kind of basket fund, you can use sector specific funds like the Consumer Discretionary Select Sector SPDR ETF (NYSEARCA:XLY) and Consumer Staples Select Sector SPDR ETF (NYSEARCA:XLP). An advantage of XLP is that, if the 2007 - 2008 crash tells us anything, it is more resistant to downturns, which makes sense. While SPY dropped from about 158 to about 67, for a 58% drop, XLP dropped only about 29%.

Financial Sector

I would bail on the financial sector. It is running way too hot. While the S&P 500 has grown 22.5% over the past year, the financial sector has grown by 43%. The consumer staples sector XLP, on the other hand, has only grown by 8.6%.

If you are feeling really lucky, and bearish, you might want to short the Financial Select Sector SPDR ETF (NYSEARCA:XLF), the fund covering the S&P 500's financial sector.

Disclosure: I am/we are short SH.

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.

Additional disclosure: I also have an overall contrarian position.