Are Stocks Overhyped Or Still Ripe?

3/9/2015


The S&P 500 Index, up 2% so far in 2015, has risen more than 10% in five of the past six calendar years. Are stocks now in danger of being overhyped and overvalued, especially as corporate profits seem likely to decline in the first half of 2015?

Below we look at this question from three angles: investors' ability to buy more stocks (based on current asset allocation), their willingness to buy more stocks (sentiment), and the attractiveness of stocks based on growth expectations and valuations.

Asset allocation

While several prominent hedge funds began to cash out of stocks last year, individual investors ramped their exposure to equities. At the end of 2014, individuals had allocated more than 68% of their portfolios to stocks — the highest proportion since June 2007, based on a survey conducted by the American Association of Individual Investors. Investors have averaged 60% in stocks since November 1987. Cash represented just 15% of investors' portfolios, the smallest amount since at least 2000 and well below the historical norm of 24%.

Conclusion: Equity-heavy portfolios may reflect investors' frustration about low bond yields. Once interest rates begin to rise, yield-starved investors could migrate back into fixed-income, creating a drag on stocks.

Sentiment

Bullish sentiment among individuals, though elevated, has yet to reach extreme levels, as shown below. But 58% of newsletter editors are now bullish, down slightly from last week's eight-month high, according to Investors Intelligence. In just 3.4% of weeks since the beginning of 1990 have a greater proportion of newsletter editors been categorized as bulls. The spread between the percentage of newsletter bulls and bears, currently 44.6%, is also unusually high. That spread has been wider just 0.7% of weeks since 1990.

Conclusion: The S&P 500 tends to rise more often than usual after weeks with bullishness from 55% to 60%. However, performance isn't as good after bullishness of 50% to 55% or 60% to 65%, suggesting the current range may not be the positive indictor it appears at first glance.

The percentage of newsletter bulls (58.7%) currently hovers near extreme levels, as done the spread between bulls and bears (44.6%)

Growth and valuation

Analyst estimates continue to shrink, with the S&P 500 Index now projected to grow per-share profits less than 2% this year. That growth target was 8% on Jan. 1, according to Thomson Reuters. We're concerned that all of the growth is expected to occur in the second half of the year.

Falling profit estimates have helped lift the S&P 500's forward P/E ratio to 17, near its highest level since the end of 2004, according to FactSet. Stocks are not cheap, but they might be less expensive than the forward P/E ratio suggests. Earnings season was awash with executives curtailing expectations. However, outside of the energy sector, management tended to blame growth woes on the strong U.S. dollar's erosion of overseas profits, rather than a decline in the underlying business.

Conclusion: Stocks are expensive, except when compared to bond yields. But the unusually strong dollar deserves at least some of the blame for weakness in year-ahead profit estimates that make stocks look pricey.

FINDING SENTIMENT'S SWEET SPOT
Newsletter editors are unusually bullish (58.7%), and the spread between bulls and bears is abnormally high (44.6%). In the three months following periods when bullishness was 55% to 60%, the S&P 500 Index rose 73% of the time, above the long-run norm of 68%. However, the market didn't perform as well during periods of slightly lower or higher bullishness. Sentiment sweet spots are in bold. Current sentiment levels are in green.
-- 3-Month Change --
Number
Of Periods
% Up
% Down
% Up More
Than 5%
% Down
More
Than 5%
Average
Return
(%)
Newsletter editor bullishness (weekly)
Below 25%
6
33
67
0
50
(5.4)
25% - 30%
30
73
27
30
23
1.0
30% - 35%
74
73
27
45
7
3.7
35% - 40%
167
75
25
46
13
3.0
40% - 45%
275
76
24
42
11
3.2
45% - 50%
322
66
34
34
14
1.8
50% - 55%
244
56
44
18
18
(0.1)
55% - 60%
157
73
27
22
7
1.9
60% - 65%
26
65
35
12
12
0.7
Total
1,301
68
32
33
13
2.0
Newsletter Bull-Bear Spread (Weekly)
Below 0%*
196
70
30
43
17
2.8
0% - 5%
107
79
21
50
6
4.1
5% - 10%
119
80
20
45
11
3.4
10% - 15%
145
79
21
44
12
3.6
15% - 20%
171
58
42
28
16
0.9
20% - 25%
177
58
42
24
21
0.0
25% - 30%
132
56
44
24
15
0.6
30% - 35%
128
73
27
22
8
1.6
35% - 40%
90
71
29
19
4
2.1
40% - 45%
30
67
33
3
3
0.6
45% - 50%
6
100
0
0
0
1.5
Total
1,301
68
32
33
13
2.0
* Meaning bears outnumber bulls.Ā  Data from Investors Intelligence, calculation by Dow Theory Forecasts.

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