By Michael Brush
What a great time to own stocks.
Three major
indicators with strong track records are signaling it's
time to sell stocks.
Here's how they work and why investors should
worry.
The Dow Jones
Industrial Average ($INDU) is setting records just
about every day. The
S&P 500 Index ($INX) has advanced 12% in less
than five months.
Technology stocks are up about 14% since
midsummer.
The giddy stock
bulls may be in for a nasty surprise. They're
ignoring three trusty
stock-market indicators -- with great records
for predicting corrections --
that currently are saying it's time to
get out of equities. The signals are
closely watched by market
technicians on the lookout for hints that the bull
run is getting
tired.
One of the indicators says stocks are simply
expensive compared with
other investment options available to big money
managers. Another
says that mutual fund managers have mostly exhausted the
supply of
dollars they have available to put into the market. And the third
says that the smartest investors are now betting on a downturn.
Together, these harbingers paint a far different picture of the
market
than do the raw return numbers.
Here's a closer look at these indicators
and why you should be
cautious with stocks now.
The stock-bond
trade-off
Money managers chiefly put money in two assets: stocks and bonds.
One way of deciding whether stocks are expensive is by comparing
their
performance to that of bonds. If bonds lag while stocks
advance, according
to some market watchers, fund managers will be
more likely to sell stocks
and buy bonds.
But how do you compare the prices of stocks to bonds?
Jason Goepfert
of SentimenTrader.com looks at the performance of the
largest bond
and stock indexes as they are embodied by two exchange-traded
mutual
funds -- the Standard & Poor's Depositary Receipts (SPY, news,
msgs), which tracks the S&P 500 Index, and the iShares Lehman 20+
Year Treasury Bond Fund (TLT, news, msgs), which tracks 20-year
government bonds. (For data that predates the funds, he compares the
S&P 500 with the 10-year Treasury bond.)
To compare them,
Goepfert contrasts the current ratio of the SPY to
the TLT with the average
ratio over the past three months. Since the
ratio typically doesn't change
much in 90 days, the two values
should be about the same. Now, though, with
the recent rally in
stocks, there's a big gap. The current ratio has moved
up to 1.58,
compared with an average of 1.5 over the past 90 days. That may
not
sound like much. But since the ratio usually stays fairly constant
in any 90-day period, this is a huge move compared with what
normally
happens.
The difference between the current gap and the 90-day average
is at
a level seen only 1% of the time. (For you statistical wonks, the
indexes are now more than three standard deviations away from the
norm).
"Stocks are rarely as overvalued to bonds as they are now,"
says Goepfert.
In the three months after such an extreme reading, the performance
of the S&P 500 has ranged from a loss of 8.7% to a gain of just
1.7%. That's a bad outlook for the bulls. It gets worse: This
indicator
has called two of the biggest market declines in the past
decade.
It
flashed red just before the big correction that started in March
2000,
signaling the end of the technology bubble. By the end of
2002, the S&P
500 had fallen more than 45%. (On the upside, this
model said buy in
mid-2002, just before the start of the current
bull rally.)
On July
17, 1998, the model said sell just before a dramatic crash
that took the
S&P 500 down 19% in the next month and a half. On Aug.
31 that year, the
model said buy just before a September rally that
took the market up 11% in
a month.
Cash-strapped mutual funds
Mutual funds are allowed to hold
cash instead of stocks or bonds.
How much cash they have on hand is often a
good signal of where the
market is heading. If they have a lot of cash, it
means there's
still a lot of money left to go into stocks. When cash levels
are
low, it means there's less money on the sidelines to drive stocks
higher. It also means that if retail investors get scared and sell
their
fund shares, fund managers will have to sell stock to meet
redemptions,
driving stock prices lower.
As of the end of August, U.S. equity mutual
funds had 4.4% of their
assets in cash, according to the Investment Company
Institute.
Goepfert adjusts this number for how much cash they should have
on
hand given the current level of interest rates. Even though interest
rates are relatively low, Goepfert figures that funds should have a
7%
cash position, according to historical trends. This means funds
have 2.5%
less cash than they "should" have, given the level of
short-term interest
rates. This is another historic extreme.
Since 1950, whenever cash
shortfalls hit these lows, the S&P 500 has
fallen 69% of the time with
an average decline of 4%. Ominously, the
last two times cash levels were
this low, bad things happened to
stocks. Cash levels hit these lows in early
2000 just ahead of the
last big bear market. Cash also hit current levels in
early 1981
just before a two-year market slump.
The smart money is
bearish
Investors, of course, always want to know what the "smart money" is
doing. To figure this out, Goepfert turns to the Commodity Futures
Trading Commission.
First, a primer on futures contracts. Traders
who own futures
contracts on a stock index like the S&P 500 have
purchased the S&P
500 stocks at a price agreed upon now, for delivery at
some point in
the future. Usually these contracts are settled in cash,
without
delivery of the underlying stocks.
To keep track of the
futures markets, the CFTC makes brokers report
client positions. The CFTC
designates the biggest traders -- those
holding more than 1,000 S&P 500
futures contracts -- as "commercial"
traders. They only make the grade if
they hold those futures
contracts as a part of a hedge to protect against
losses in
underlying investment positions. Goepfert considers these
commercial
traders to be the "smart money." (The other two categories are
big
speculators, who hold 1,000 or more S&P 500 futures contracts that
aren't part of a hedged position, and small speculators, who hold
less
than 1,000 contracts.)
Right now, commercial traders have a $30 billion
net short position
in futures on the S&P 500, the Dow Jones Industrial
Average and the
Nasdaq Composite Index ($COMPX). Going short is a bet
against the
market. Traders go short by borrowing securities and selling
them,
hoping they will be able to replace them later at a cheaper price
after a market decline.
This is only the third time in recent history
that this short
position has been so large. The other two times were early
2001,
just before the S&P 500 tumbled 38%, and November 2004, after
which
the market rose some more and then corrected in early 2005.
A
ray of sunshine
Taken together, these three indicators say its time to be
more
cautious with stocks -- but they don't mean that a sharp correction
is 100% certain.
Here's just one dissenting voice: Robert Froehlich,
chairman of the
investor strategy committee at DWS Scudder, the U.S. mutual
fund
division of Deutsche Bank. Froehlich points out we are moving into
the seasonally bullish phase for stocks. This is the six months from
early November to the end of April, a period Froehlich calls "turkey
to
tax time." Since 1950, the average return of the S&P 500 during
this
phase has been 9%. The average return of the S&P 500 during the
other
six months of the year was only 2.71%.
At the time of publication,
Michael Brush did not own or control any
of the equities mentioned in this
portfolio.