Market Overview

Are Stocks Overbought, Overvalued, Over-Owned & Over Exuberant?

Are Stocks Overbought, Overvalued, Over-Owned & Over Exuberant?

One of the arguments emanating from the bear camp is that the U.S. stock market is overbought, overvalued, over owned, and over exuberant.

And as you might surmise, those seeing the glass as at least half empty contend that such a combination is both (a) rare and (b) fatal to bull markets.

Of course, it is important to keep in mind that this is the same crowd that was pounding the table twelve months ago about the uber negative macro picture which included the sequester, the euro (NYSE: FXE) falling to pieces, China (NYSE: FXI) heading toward a hard landing, and the good 'ol USofA dipping back into recession. And for the record, how'd those calls turn out?

Our Furry Friends May Have A Point This Time

While the bulls have certainly enjoyed taunting their opponents in 2013, it is important to recognize that the day the reset button gets pushed is growing closer. Therefore, it might be best for players on both teams to take a step back and review the landscape with an objective eye.

For example, those adorned in their rose-colored Ray Bans may want to take a look at some of the big picture indicators and keep in mind that all good things come to an end, eventually.

See also: The Reason For Wednesday's Hard Fall In Stocks

So, this morning, let's take a look at the argument that sentiment in the stock market is entirely too optimistic at the present time. (And next week we'll explore the rest of the questions.)

Are Investors Over Exuberant?

Each week, Investors Intelligence surveys investment advisors and rates their advice as Bullish, Bearish or "Expecting a Correction." In the last four weeks, there has been an average of just 14.9 percent outright bears. The bottom line is this the lowest level of the four-week moving average since 1987. As such, there are fewer bearish advisors now than there were at the bubble peaks of 2000 and 2007. Yikes.

Another way to use the data from Investors Intelligence is to look at the 10-week moving average of the percentage of bulls divided by the sum of bulls plus bears. History shows that when the 10-week average moves above 67, stock market sentiment is considered to be extremely positive. In fact, Ned Davis Research tells us that since 1970 when the 10-week average is over 69, the DJIA (NYSE: DIA) has returned just 0.2 percent per annum.

An Indicator To Watch

Taking this idea a step further, one can create a pretty darn good sell signal with this data. As we noted above, when the 10-week average is above 69, it indicates that sentiment has reached an extreme level. The trick is to then wait until the average drops below the 67-level. This is an indication that the sentiment extreme has started to reverse - and that it's time to get the heck out of the way.

See also: Look Before You Take Market Leaps In 2014

Since 1970, this little indicator has produced a total of 16 sell signals. The most recent of which came on October 9, 2013. Of the prior 15 signals, the market moved lower - oftentimes significantly so - 14 times. And in fact, this particular sell signal was flashed before the important declines seen in 1973, 1977, 1987, 2007 and 2011.

So, with a fresh sell signal from this long-term indicator, history suggests that the bears might actually have something crow about soon.

What About Real, Live Money Managers?

Next up, let's take a look at what real, live money managers are doing with the money they've been entrusted with. The National Association of Active Investment Managers (NAAIM) reports each week on the equity exposure level of their member firms. While the exposure of this group will vary from week to week, from a big picture standpoint, the overall exposure tends to be low in bearish environments and high in bullish environments.

According the originator of the survey and past NAAIM President William Hepburn, “NAAIM advisors absolutely nailed the 2008 decline by steadily reducing equity allocations beginning in late 2007.” Hepburn goes on to say, “NAAIM members had an average equity exposure of only 19 percent from June 2008 through March 2009.”

Therefore, it is interesting to note that the NAAIM Index hit an all-time high just two weeks ago with a reading of 101.45 percent. This means that on average, the active managers in NAAIM were more than 100 percent long the stock market at that time. Granted these money managers aren't potted plants and they can adapt to a changing market environment at the drop of a hat. But the key takeaway here is that at 101.45 percent, there isn't a lot of money sitting on the sidelines in this group!

Although the survey is just seven years old, Ned Davis Research notes that when the NAAIM Survey is above 73 percent (which occurs approximately 23 percent of the time), the S&P 500 (NYSE: SPY) has lost ground at an annualized rate of -3.8 percent per year. This is likely due to the fact that by the time the survey sports a high reading; most managers have already established long positions.

So, if you aren't as nimble as the professionals in the NAAIM organization and the current level of bullish sentiment makes you a bit nervous, it might be a good time to start thinking about what your exit strategy might be if things turn ugly. Because based on some pretty good indicators, it looks like the bears could awaken from their recent five-year hibernation at some point here soon.

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