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Sunday, April 17, 2011

Forecast a Stock-Market Top in 2011

(MarketWatch) — How will we know when the bull market is finally coming to an end?






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This is a particularly timely question right now, given the extraordinary cross currents that are buffeting the market. My columns in recent weeks have reflected those conflicting forces, with some of the advisers I've quoted contending that the bull is alive and well, and others arguing that the bull is living on borrowed time.



For insight, I turn to Ned Davis Research, the quantitative research firm, which looks to a basket of indicators to help determine when a market top is imminent.



It is interesting to note that, nearly two years ago, I turned to this same firm for help in answering this very same question. At the time, many were convinced that the market's rally was nothing but a bear-market correction. But Ned Davis, upon analyzing his various indicators of a potential top, concluded that the bull market had further to go.



What's his firm saying now?



In an interview earlier this week, Ed Clissold, the firm's Global Equity Strategist, said that — though there are some worrisome signs on the horizon — for now his firm is giving the bull the benefit of the doubt.



The top-identifying indicators that the firm looks to fall into four major categories, according to Clissold. They are:



Valuation



Clissold told me that, though stock valuations aren't yet at such an extreme as to cause this category of indicators to flash a sell signal, there are some causes for concern.



One of these causes for concern, according to a letter Davis sent to his institutional clients earlier this week, is that "profit margins on the S&P Industrial Average are at record highs. ... Using data back to 1954, very high profit margins, on average, have not been bullish for stocks, because the series is very mean-reverting."



Another source for concern, which Davis also highlighted earlier this week, is the cyclically adjusted P/E ratio that Yale professor Robert Shiller made famous.



At the same time, however, Clissold referred to other valuation measures that suggest stocks are not particularly expensive right now — such as the P/E ratio based on 12-month earnings (as opposed to the 10-year average that Prof. Shiller prefers).



All in all, a split decision on valuation. As Davis wrote earlier this week: "I can certainly understand the bullish stance of those who argue stocks are still reasonably priced, based upon current earnings. Yet, I don't think that presents a complete picture of potential risks. I am just providing the evidence for clients to make their own decisions."

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Sentiment



This is the one category out of the four that, in Davis' opinion, comes closest to yelling "sell." He maintains two sentiment indices, one of which is well into the zone of excessive optimism and the other on the border of that zone. On contrarian grounds, that is worrisome.



Market breadth



This is the category that is perhaps the most bullish, according to Davis. "One of the key characteristics of a major top in the stock market is considerable divergences," Davis wrote earlier this week, and there are few signs of that.



One of the indicators on which Davis relies for evidence of divergencies is called the "High Low Logic Index," which represents the lesser of new 52-week highs or new 52-week lows as a percentage of all issues traded. The High Low Logic Index traces back to a metric created three decades ago by Norman Fosback.



In his book Stock Market Logic, Fosback describes its rationale as follows: "Under normal conditions, either a substantial number of stocks establish new annual highs, or a large number set new lows — but not both. As the [High Low] Logic Index is the lesser of the two percentages, high readings are therefore difficult to achieve. … When the Index attains a high level, it indicates that the market is undergoing a period of extreme divergence. … Such divergence is not usually conducive to future rising stock prices."



Currently, according to Davis, the High Low Logic Index is bullish at 2.4%. At the stock market top prior to the 2007-2009 bear market, in contrast, it rose to close to 6%. The only other time in recent decades when this index got this high was in early 2000, right before the popping of the Internet bubble.



Interest rates



Clissold told me that this category, like valuation, is providing some causes for concern, but is not yet outright bearish.



The concerns derive from higher rates, which have caused some of the firm's interest-rate trend indicators to enter into bearish territory. However, Clissold added, he doesn't think that these concerns yet amount to a "screaming sell signal."



One straw in the wind that he recommended we be on the lookout for would be the 10-year Treasury yield rising to around 4.25% — three quarters of a percentage point above its current level.

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