Are Stocks Overbought? These Little-Known Indicators Say Yes

By (dsterman),

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The S&P 500index rose another 3% last week, continuing a winning stretch that began last fall. 

Since Nov. 7, the S&P has risen 22%. That works out to be a roughly 35% annualizedgain . Trouble is, therally is increasingly due to a perception by individual investors thatstocks can only move in one direction: up.

In its most recent survey, the American Association of Individual Investors (AAII) noted that the percentage of investors who are currentlybearish is now less than 20%. That's the lowest reading in 18 months, yet as legendaryfund manager Sir John Templeton once noted, "The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell."

I've already researched one half of that maxim. Back in 2010, I noted that stocks tend to rally when that AAII survey finds fewbullish investors. The logic is quite simple: When investors are in a negative mood, they have already pushed stocks down to levels that are too low to ignore. As Templetonnotes , maximum optimism should be of equal concern.

Discussing the sharpgains posted in themarket last week, MKM Securities' Katie Stockton noted that "short-term momentum was strong enough to lift the S&P 500 above its June levels, while generating abundant breakouts on the individualstock level. Breakouts tend to foster additional momentum," which she adds can lead to overbought conditions. 

In effect, technical indicators like momentum -- not fundamental indicators like valuations and growth rates -- are ruling this market.

TheProfit Disconnect
It's important to think aboutissues such as momentum and investor bullishness as we head intoearnings season , whichwill replacespeculation with fact. Companies in the S&P 500 are expected to boost profits 3% from the same quarter lastyear , though the actual figure is likely to end up closer to 4% or 5% once the numbers have been digested. In each of the past three earnings seasons, year-over-year profit growth has been 1 or 2 percentage points above early season forecasts.

Yet the real risk to stocks will be based on what companies have to say for the rest of 2013. Both a strong dollar (which mutes foreignearnings ) and a fresh slowdown in key emerging market economies could easily compel companies to set a lower bar for the next twoquarters .

Margin Concerns
There's an unusual stock market correlation that has developed over the past 15 years that investors should heed. In 2000 and 2007, the amount ofmoney that investors had borrowed to buy stocks (that is,margin debt ) surpassed $350 billion. In both cases, the stock market was sharply lower a year later, partially induced by forced margin selling -- and more importantly, the U.S.economy had slipped intorecession by then. It's as if investors became overly aggressive with margin debt right at a time when they should have been tilting toward caution.

Well, for the third time in 15 years, margin debt has again moved above $350 billion. The figure has stayed constantly above that threshold for the whole year. (Data are only available through May, which saw a modestdowntick , likely induced by "tapering" comments by the Federal Reserve on May 21, though the trend may have been reversed as those tapering comments have subsequently been walked back. The next data will be released in late July.)

The Move ToCash
Thanks to aggressive recent stock buying, many investors have come close to exhausting their sidelined cash and are "all in," as they say in poker. But having all of your chips on the table can be dangerous, especially if you carry margin debt as well. 

So while your gut may tell you to stay focused on further market gains, your head should be talking you into locking in profits. Yet which stocks should you sell during this earnings season?

In market environments with less froth, you should always seek to cull the bad stocks from your portfolio and "let your winners ride." But the current environment, which has seen more than 90% of the stocks in the S&P 500 move above their200-day moving average , means that even great stocks should be in question.

My rule of thumb: Unless a company can make a solid case for robust profit growth over the next few years, the time may be here to take profits. 

I would also prioritize my portfolio, separating the low-priced stocks (interms of price-to-earnings, price-to-book, or price-to-cash flow) from the high-priced ones. Though both types of stocks would flourish if the market moves yet higher, the lower-priced stocks at least have betterdownside protection if the market moves lower. Lower-priced stocks are also more likely to initiate share buyback ordividend hikes if the market comes under deeper pressure.

Risks to Consider: With U.S. trading partners in distress, this coming earnings season could take a much more somber tone. This is no time to be complacent (even though theVIX index -- the "fear gauge" -- is again below 14, signaling historically high levels of complacency). 

Action to Take --> Instead of focusing on the market, keep a close watch on the stocks in your portfolio. Examine the coming quarterly results (and outlooks). Merely "decent" business conditions are no longer grounds to hold any stock that has appreciated sharply in recent quarters.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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This article appears in: Investing Basics
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