Stock Market: Be Careful Now

Stock Market: Be Careful Now

stock market bear

2014 is no party for stock market investors. January was a smack in the face, especially newcomers, as the markets decided to go for a 5 percent nosedive. But they again recovered in February and some indices put up new all-time highs; others are on the fence and you can feel that doubt is creeping in as investors are starting to feel uncomfortable having a large part of their portfolio invested. As a result, March also turns out to be a challenging month for stocks. And this should not come as a surprise, as different signals indicate that the market situation is getting overheated.

We cannot blame anyone here. The current bull market has recently had its fifth birthday and is almost breaking the top 3 of the longest stock market rallies in history. With an increase of 147% for the Dow Jones index from its March 2009 low, it is obvious that the magnitude and momentum of this bull market is just as qualified for the history books as its duration. That is clearly visible on the next chart (source: Barclays).

Bull markets - duration vs magnitude

You can also see that we have seen better and longer bull markets in the past. In the ‘50s, we had a seven year bull market and the bull market of the ‘90s lasted for almost ten years! Just to be clear: a bull market remains theoretically intact as long as an index does not drop by more than 20 percent from a high. There is plenty of upside in other words, but the air does get thinner the higher we go. Naturally, the upward potential has decreased and as history has taught us, at one point the cable on this elevator will snap and we will go down a lot faster than we came up.

The question, of course, is when will the music stop? That has always been a tough call to make. With regards to valuation, we are already in overtime at the moment. The markets are generously valued at this point, more specifically when looking at market capitalization versus GDP (Warren Buffett’s favorite indicator). Another comparable ratio, however, is also showing warning signs. The Tobin Q ratio measures the total market cap of non-financial listed companies in relation to the replacement value of the assets of these companies. The ratio is a good check to see if the fair value of these companies is deviating from their stock price. Above 1x, this ratio indicates that investors are prepared to pay a lot more for expected performance and goodwill.

Tobin Q

The above chart from Ed Yardini clearly shows that the actual position of the Tobin Q ratio, as well as the adjusted version, has been living north of the 1x level since the fourth quarter of 2013. In the past, namely in the seventies, the current position would have been enough to cause turmoil. Naturally, there are exceptions as evidenced by spike around the dot com boom, but still…

Still, it feels like the 2000-period on the stock market. Just have a look at the chart below, which compares the S&P 500 to the Rydex Asset Ratio (Bears versus Bulls). It’s been 13 years since the ratio dropped this low. Investors are pouring massive amounts of cash into equity funds (long only) and liquidating their short / hedge funds and money market funds. This again is huge warning sign for the markets.

Rydex Asset Ratio 2014

And that is precisely the problem investors have today. On the one hand, valuation and duration are above average, but that does not necessarily mean that we are at the dawn of a big stock market correction. This stock market rally could last for a few more years and valuations have a lot more room to grow before we can even start talking about a bubble. On the other hand, it is clear that the rally is having a tough time repeating its 2013 performance, at least for now.

That is why vigilance is in order. Indeed, investing is making an estimation regarding the future, taking healthy probabilities into account. As the market rally persists, its effective life span decreases; that is pure logic. Unfortunately, logic is not always what governs the stock market. Nevertheless we have become more careful in 2014 and have advised our subscribers to take profits of the table here and there, without getting out of the market completely. We rather wait and see for now as things could go either way from this point.

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