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Investors beware -- signs point to stock bubble

The S&P 500's surge to new record highs on Wednesday does, on the surface, look like a good thing. Retirement portfolios are swelling. Confidence is building. Households' net worth is growing.

Now for the bad news: Growing evidence suggests that stocks are in the final throes of a five-year-old bull market. And like all such bull markets, this one is starting to show signs of bubble-like behavior that have a tendency to suck in the least informed investors before splattering them in losses.

Consider today's trading action. Net advancing issues on the New York Stock Exchange were down more than 20 percent from Tuesday. Buyers were focused on a narrow subset of heavily weighted stocks in the S&P 500, including Microsoft (MSFT), Apple (AAPL) and Cisco (CSCO). Energy, utilities and retailers were in the red. Big bank shares were helped by earnings from Bank of America (BAC), which beat on the top- and bottom-line, despite a near 50 percent drop in mortgage originations, thanks to a big release of loan loss provisions.

The "yen carry trade" also played an important role, with the stock market closely mimicking the movement in the dollar-yen exchange rate since early November. Why are stocks, which are supposed to be sensitive to things like earnings and the business cycle, moving in tight lockstep with currencies that respond to things like interest rates, inflation and trade balances? Because hedge funds are using ultra-fast computer trading algorithms to sell the yen short, using the proceeds to buy dollar-denominated assets like the stocks in the S&P 500.

Or how about the reaction to Tuesday's news that Google (GOOG) would buy fancy thermometer maker Nest for $3.2 billion? That pushed up shares of unrelated pink-sheet stock Nestor by nearly 5,000 percent in a repeat of the excitement seen heading into the Twitter IPO. Back in October, shares of Tweeter, an electronics retailer that went bankrupt in 2007, surged more than 2,200 percent as overeager traders jumped the gun on an unrelated stock.

Of course, measures of investor sentiment and position remain at extremes, with the relationship between bulls and bears at levels not seen since 1987, while margin debt remains at record highs as cash holdings dry up.

The upshot? From a valuation perspective, the market is expensively priced. Yale economist Robert Shiller's cyclically-adjusted S&P 500 price-to-earnings ratio, which uses 10-year average earnings to smooth volatility, stands at 25.3. That is more than 1.3 standard deviations above the long-term average of 16.5 going back to 1880.

Translation: In 134 years of market history, stocks have been more expensive than they are now less than 10 percent of the time. My recommendation is to fight the urge to suspend disbelief and focus on the combination of value, safety and renewed buying interest offered by precious metals mining stocks such as Tower Hill (THM), which is up 16 percent since I added it to my Edge Letter Sample Portfolio on Jan. 2.

Disclosure: Anthony has recommended THM to his clients.

  • 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.