The Stock Market Is Starting to Look Toppy

From a big-picture perspective, the stock market’s advance off the March 2009 low is nothing more than a huge, bear market rally.

To understand how I come to that conclusion, just look at two classical valuation measures, price-to-earnings ratios and dividend yields, in the chart below. You can easily see how this stock market bear, which started in 2000 at record overvaluations, still has a lot of work to do …

S&P 500, Price Earnings Ratio, and Dividend Yield,
1926 to 2010

With a price-to-earnings ratio of 23.39 on a twelve-months trailing GAAP earnings basis, valuations are as high as they usually get during an upward cycle.

And the dividend yield is under two percent. That’s way below the three percent threshold, historically indicating an extremely overvalued market.

Meanwhile, Bullish Exuberance
Is Back to Dangerous Levels

Do you remember the depressive sentiment during the depth of the crisis in late 2008 and early 2009? It looked like the world was coming to a standstill. Everybody seemed to hate the stock market. Even mainstream economists who tend to be bullish and upbeat all the time showed signs of doubt.

About a year and a half later that picture has changed dramatically!

Bullish forecasts for the economy and the stock market are back in vogue. In fact, Investors Intelligence is telling us that 51.1 percent of stock market advisors are bullish again, back up from less than 25 percent during the fourth quarter of 2008.

As shown in the bottom panel of the above chart, the number of financial newsletters leaning bullish is on the rise, too … well above the 2.0 level considered a bullish extreme.

Even more important, though, is the bullishness of mutual fund managers …

The average mutual fund cash level has fallen to a mere 3.5 percent as indicated in the following chart. In hitting that level, this important sentiment indicator has tied the record reached during the summer of 2007.

Equity put-call ratios are also falling dramatically, reaching euphoric levels not seen since 2000.

Conclusion: The Air Is Getting Thin for the Stock Market

The stock market has rallied roughly 80 percent since the March 2009 low bringing valuation metrics back to nose-bleed levels. Money supply growth has tumbled to a trickle, while stock market sentiment is back to euphoric highs.

And we still have to deal with a housing market that’s in shambles, an economy lacking growth momentum, and 9.7 percent unemployment!

All these observations add up to one compelling conclusion: The stock market has entered the last phase of the huge bear market rally off the March 2009 low. And the next few months will probably show the topping phase, the prelude of the next bear market leg.

Best wishes,

Claus