Is the market overvalued?

Stocks inched higher again Friday, brushing off concerns about a Russian incursion into the Crimea, helping the S&P 500 gain 0.3 percent to move deeper into record territory. For the week, the index gained 1.3 percent as it pushed above resistance that had kept it below the 1,850 level since November.

After a quick up-and-down related to problems with emerging market currencies, as well as simmering credit woes in China, the bulls have pushed the stock market right back to where it was late last year.

But something is different this time.

For one, buyers are much more narrowly focused on what they're buying, a sign that valuations are becoming stretched here. An analysis by James Montier at GMO shows that on a number of valuation metrics, the S&P 500 is "significantly overvalued" and suggests that at these levels, investors should expect to merely breakeven over the next seven years. That's right. A zero percent return.

The majority of the underperformance is expected to be generated by a contraction in corporate profit margins, which are at stratospheric heights relative to labor's share of national income (a relationship that should revert to a more normal relationship as the job market tightens), as well as a drop in price-to-earnings multiples (a reflection of the fact investors will be less thrilled to own stocks in a falling profitability environment).

You can see this narrow interest in the way the percentage of NYSE stocks above their 50-day moving average is peaking around 67 percent vs. a high of 72 percent in mid-January and 85 percent back in October. There are simply fewer attractive opportunities out there at current valuations.

It's not for a lack of trying: Based on the nine-day moving average of the McClellan Oscillator (which is a measure of breadth momentum), buyers have reached exhaustion points associated with market tops in January, September, July, and May. (The October-November meltup is the exception here.)

The repeated intra-day reversals we've seen this week suggest the buyers are becoming fatigued after repeatedly trying to get the S&P 500 to new record closing highs.

Through Wednesday, the S&P 500 had been rejected at the 1,850 level three times in a row. That's something that had only happened four other times in the last 30 years. After the other four, according to the folks at SentimenTrader, the market showed a modest upside bias over the short-term before rolling over into losses over the two-to-three month horizon each and every time. The dates were in August 1991, May 2006, May 2007, and December 2009.

And finally, the CBOE Volatility Index or VIX, colloquially known as Wall Street's "fear gauge" (and based on what's happening in the options market) is inching higher as traders protect themselves from a market selloff. Whereas the VIX was testing lows around 12 in November and December, it's up around 14 now -- a sign that folks are feeling a little more nervous out there.

To be sure, with the Federal Reserve's "QE3" bond purchase stimulus no longer a sure thing, with the Chinese banking system showing renewed signs of stress as Beijing actively weakens its currency on a scale not seen since 2008, with political turmoil in Ukraine and Turkey, and with the economic data here at home continuing to disappoint as the winter freeze thaws, there is much to worry about.

I continue to recommend investors use the current environment to trim weaker positions, book some profits, raise a little cash, and prepare for a resumption of the dynamism we saw in the market back in January. I'm clearly not the only one, with money flowing into the class safe haven asset, U.S. Treasury bonds, pushing the iShares 20+ Year Treasury (TLT) up and out of a month-long downtrend.

In response, I've recommended more aggressive, leveraged ETF exposure to the move to my clients via the Direxion 3x Daily Treasury Bond Bull (TMF), which I've also added to my Edge Letter Sample Portfolio.

Disclosure: Anthony has recommended TMF to his clients.

Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters, as well as Mirhaydari Capital Management, a registered investment advisory firm.


  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.

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