Investors: What To Do As The Market Is Way Overvalued

Claus Vogt:  There are many reasons to expect the current cyclical bull market in stocks to give way to the next vicious bear. Let me give you my top six.

First of all …

The Market Is Way Overvalued

As I’ve written before, all traditional fundamental valuation measures like price/earnings ratios, dividend yields and Tobin’s Q ratio unambiguously come to this conclusion.

Then last week Jeremy Grantham, the famous value investor, published a missive stating that according to his methodology the S&P 500 (NYSE:SPY) is 45 percent overvalued. He calculates fair value at 920.

I want to add that secular bear markets — like the one that started in 2000 — do not end at fair value but in clearly undervalued territory. Hence risks are very high.

Second …

Sentiment Indicators Are about as Lopsided as They Can Get!

Investors Intelligence Advisors Sentiment showed more than three bulls for every bear during four of the past six weeks, a very unusual stretch of bullish sentiment.

Plus, the Investment Company Institute’s latest figures show that the cash level of investment funds hit a record low 3.4 percent in March. Never before have fund managers been more heavily invested in stocks than now — not during the high of the stock market bubble in 1999/2000 and not at the top in 2007.

Third

This Cyclical Bull Market Is Statistically Running Out of Time

Cyclical bull markets in times of secular bear markets have historically lasted a little more than two years. The current cycle low dates back to March 2009, which gives this bull market an age of nearly 27 months.

In and of itself the duration of a bull market is of little meaning. But coupled with severe overvaluation and irrational exuberance the mature age of this bull adds an additional argument to become very cautious.

Fourth …

QE2 Will Soon Be History

Nine months ago the economy and the stock market looked ready for a double dip. Then Ben Bernanke entered the scene and announced QE2.

His goal of lowering long-term interest rates in this monetary campaign was a flop. The economy regained some strength though — probably due to the accompanying tax cuts. Consequently the stock market experienced an impressive wave of speculation lifting the S&P 500 12 percent above the April 2010 high.

The well-announced end of QE2 is quickly approaching. Come the end of June the Fed will be done. For the time being QE3 seems to be out of the question, depriving the market of important support.

Fifth

Commodities and the Dollar Have Just Experienced Strong Reversals

The silver (NYSE:SLV) market has made a deep reversal. From its high of around $50, it dove all the way down to $33. That’s a 35 percent haircut in a mere six trading days.

Other commodities have also gone through major trend reversals, namely crude oil (NYSE:USO), copper, and lumber. All three are leading economic indicators. Therefore these reversals may well contain a bearish message for the economy.

An important trend change has also developed in the dollar.

During the last few years the dollar has shown an interesting pattern compared with other financial markets …

A weak dollar was accompanied by rising risk assets like stocks, commodities, and junk bonds. And a strong dollar coincided with falling risk assets. This correlation still seems to be working with commodities down and the stock market in a corrective mode.

Already the euro has fallen a hefty 8 cents from its 1.50 high in just a few days. If this trend reversal of the dollar is for real — and I think it is — then the stock market is likely on the verge of a negative surprise.

Sixth …

Emerging Markets Are Looking Weak

On a global basis the S&P 500 is somewhat of an outlier right now, since it managed to make a new cyclical high at the end of April.

Most international stock markets did not have the strength to follow this lead, including: Australia, Brazil, France, Hong Kong, India, UK, Mexico, Russia, China, Switzerland, and Japan.

As you can see in the chart below, the BRIC countries are exhibiting weakness compared to the S&P 500. Their index is looking very ominous, like a huge topping formation in the latter stages.

Data Source: Bloomberg

Most emerging market central banks have begun to tighten their monetary policies. Last week China raised reserve requirements for the fifth time this year. Tighter monetary policy almost always leads to a marked economic slowdown — if not to a full blown recession.

Emerging stock markets tend to lead the U.S. market. They were the first to hit bottom during the last bear market. And now they may again be leading the way into the next bear market.

Therefore this could be a good time to consider an inverse emerging markets ETF, like ProShares Short MSCI Emerging Markets ETF (NYSE:EUM). If you buy it at current levels between $30-$31, I suggest putting a stop loss at just below $30.

Related Tickers: Direxion Daily Small Cap Bear 3X Shares (NYSE:TZA), ProShares UltraShort S&P500 (NYSE:SDS), Direxion Daily Financial Bear 3X Shares (NYSE:FAZ),  ProShares Short S&P 500 (NYSE:SH), Direxion Daily Small Cap Bull 3X Shares (NYSE:TNA), Direxion Daily Financial Bull 3X Shares (NYSE:FAS).

Best wishes,

Written By Claus Vogt From Money And Markets

Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Nilus Mattive, Claus Vogt, Ron Rowland, Michael Larson and Bryan Rich. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Andrea Baumwald, John Burke, Marci Campbell, Selene Ceballo, Amber Dakar, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau, Jill Umiker, Leslie Underwood and Michelle Zausnig.

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