Sentiment and Valuation: Signs of Caution?

07/28/2014 9:00 am EST

Focus: STOCKS

Marvin Appel

President, Signalert Asset Management LLC

Ned Davis Research recently released a survey of several longer-term sentiment and valuation indicators that have a similar theme: This market rally is getting overdone and is at risk for a correction, observes Marvin Appel, editor of Systems & Forecasts.

One indicator shows that money market fund assets are near record lows as a percentage of stock market capitalization. Similar nadirs were touched prior to the market peaks of 1987, 1998, and 2000.

Another indicator is the Investors Intelligence survey of investment newsletters. This is considered to be a contrary indicator at extremes, meaning that newsletters have been most bullish overall near market tops and most bearish overall near market bottoms.

Since 1970, during periods when 68% or more of newsletters were bullish, the Dow Jones Industrials gained just 0.9%/year.

The reading, as of July 3, 2014 was 77%, down slightly from the peak of 80% reached at the start of the year. The last time readings were above 80% was in 1987.

In addition to these two indicators, Ned Davis also cites several valuation metrics that suggest the market to be overvalued.

All of these suggest that the current rally that began in October 2011 is due for an interruption. That outlook agrees with the observation that the Federal Reserve is pulling back on its stimulus programs.

Even though the Fed is tip-toeing very slowly to the exit, the fact is that we are in a new regime of Fed retrenchment rather than Fed expansion. That removes a key source of fuel for the market's rallies since 2009.

However, neither sentiment nor valuation indicators have been useful as precise timing tools, as stocks have often continued higher for months following warning signs.

I recommend that you view valuation and sentiment as intermediate-term warning signs that should motivate you to take seriously any sell signals that we may receive.

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