Are stocks overbought? Some indicators say yes

As we head into earnings season, signs of froth abound, and even the best stocks should be scrutinized.

By StreetAuthority Jul 16, 2013 6:21PM
Image: Stock market (© Corbis)By David Sterman

The S&P 500 Index ($INX) 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% annualized gain.

Trouble is, the rally is increasingly due to a perception by individual investors that stocks can only move in one direction: up.

In its most recent survey, the American Association of Individual Investors (AAII) noted the percentage of investors who are currently bearish is now less than 20%. That's the lowest reading in 18 months, yet as legendary fund 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 few bullish 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 Templeton notes, maximum optimism should be of equal concern.

Discussing the sharp gains posted in the market 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 individual stock 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.

The profit disconnect
It's important to think about issues such as momentum and investor bullishness as we head into earnings season, which will replace speculation with fact. Companies in the S&P 500 are expected to boost profits 3% from the same quarter last year, 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 foreign earnings) and a fresh slowdown in key emerging market economies could easily compel companies to set a lower bar for the next two quarters.

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 of money 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 into recession 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 modest down-tick, 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 to cash

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 their 200-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 (in terms 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 better downside protection if the market moves lower. Lower-priced stocks are also more likely to initiate share buyback or dividend 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 the VIX 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.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.


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15Comments
Jul 16, 2013 6:43PM
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Time to bring the pain and show the newbies that the market goes down as well. The Aug.-Oct. period is knocking on the door. In my many years of market experience, it is on average the worst time to be in the market.
Jul 17, 2013 10:23AM
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This rally is a whole different animal, the basis of which we've never experienced before.  This grand experiment by all the central banks around the world is just that, a never-before-tried experiment.

So, many of the same old indicators just don't matter as much anymore.  Volume continues at a trickle and has been for more than a year now.  This would have been important in the past, but doesn't seem important now.  Shaky GDP growth below 2% would have killed previous rallies, but not this one.  Excruciatingly slow job growth would have put a damper on prior outlooks and rallies, but it actually helps this market as QE become more certain than ever.  Add in massive gov debts, uncertainty about Obamacare implementation, poor numbers coming out of Europe, and oil over $100/barrel and you'd have more than enough to decimate any previous rallies.  And yet we march higher.  The old rules and indicators don't apply anymore.  QE trumps all.
Jul 16, 2013 11:22PM
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good tip there vet.  i think this writer way, way overestimates the savvy of the individual investor with his attempt to educate them on the micro view of individual stock analysis (bottom up analysis?).

 

most diy investors simply jump on the momentum wagon, get hammered, then jump off and miss the next recovery rally.  he does have some good comments on the aaii contrarian indicator.

 

be safe out there ....

 

hi r-t, hope all is well with you ... i continue to enjoy your posts ..

Jul 17, 2013 10:13AM
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Are stocks over-bought? YES, by like... 99.999999999%.

 

A "business platform" is a worthless piece of crap made out of cardboard by administrative lowlifes. A BUSINESS is an enterprise that thrives on quality and integrity and has employees who buy what they make and do. All we have are business platforms today, so guess what they're really worth?

Jul 17, 2013 9:22AM
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"Mattel said Wednesday its second-quarter net income fell 24 percent, hurt by weak sales in North America and continued softness in Barbie sales,"

 

Time to make "Banker Barbie" and "QE Ken" boys.

Jul 17, 2013 10:16AM
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Know when to hold'em, know when to fold'em.
Jul 17, 2013 12:56PM
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This bull market is driven mostly by almost zero interest rate that the banks offer for the saving accounts. If not the stock market where would one put their savings. .

Recently. It appears that some monies are pull out of the stocks and invest in houses/

 

This low interest rates scares me to no end. Will it continue forever? Consider what happens to the economy and the stock market once the interest rates rises.

Interest rates used to be a tool for controlling inflation and the economy now this tool is no longer available.

 

Jul 17, 2013 10:56AM
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VL: If theDow is 99.95 overvalued, then the Dow should be at 15.We`ld have WW3 long

before that.

Jul 17, 2013 2:57AM
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Doing good ActV.....Noticed author said; "shouldn't have all  your "chips" on the table..."

If you don't, you can't play..

 

A better wording would have been: Don't have all your chips in the pot....We don't.

Been re-organizing, pulling some cash on hi-fliers or stagnaters after divs....

Looking for better, or a pullback...For decent opportunities. 

Then, maybe then we might just "go all in."

But we all know that can be dangerous..

I was surprised by the "margins" outlay....Got away from that 15 years ago..

Jul 16, 2013 8:36PM
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Yup a little concerned about Late Summer, seems we didn't take it in the shorts too much in May or June, but they tried..

And then we have Bennie to deal with...

Jul 16, 2013 8:33PM
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That was a little sarcasmmm....I've gotta start marking some of that stuff..

 

I got a pretty good idea, and did get bent over 2008-09, but have flourished since..

So I'm not panicked and don't run around like a chicken anymore.

Corrections will harden you, and I just strive to get even.

In '87 I mostly had just 401 investments and maybe a few certificates at home, from bonuses or awards..

Remember when they actually had Stocks Certs, with names on them and everything..?

Had several when I retired; Had even bought or had some transferred from fellow employees.

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