2 More Reasons To Worry About Stocks

With the Fed meeting finally out of the way, traders can now turn their attention to other things happening in the markets such as rising interest rates, the wild action in the currency markets (if you haven't seen it recently, be sure to check out the PowerShares U.S. Dollar Index UUP), the question of where commodities are going, China's stimulus plans, that hot new IPO, the ongoing geopolitical issues, and of course the fundamentals of the stock market.

One of the big debates going on in the stock market at the present time has to do with valuations. Some argue that stocks are wildly overvalued, while a great many traditional indicators suggest stocks are no worse than fairly valued.

However, there are some lesser-known valuation indicators as well as some sentiment indicators that should give even the most ardent bull pause.

The Price-to-Sales Ratio is Through the Roof

Exhibit B for those who believe valuations are a problem (Exhibit A is the Shiller valuation model) is the Median Price-to-Sales ratio for the S&P 500. Over the past 50 years, the norm for the median P/S ratio has been 0.88. However, take a peek at the chart below...

Median Price-to-Sales Ratio - Monthly from 1965

With the median price-to-sales ratio at 2.08, the word you are likely looking for is "Yikes!"

Even if one accepts the argument that today's valuation metrics have to be viewed in a different light than they did prior to the 1990s, the current P/S ratio is still, well, "way out of whack" with even the recent past. In fact, the current 2.08 reading represents an all-time record high.

While the all-time high really says it all, it is worth noting that the current median P/S ratio is higher than it was in 2007, much, much higher than 2000, and nearly 2.5 times the level seen in 1987.

Here's the important part. History shows that when the median P/S ratio has been above 1.5ish, the S&P 500 has gained ground at a rate of less than 0.1 percent per year. 

Related Link: 3 Of The Fed's Biggest Bets

Of course, the problem with valuation indicators is they have almost NO bearing on the short- and intermediate-term moves in the stock market. So, while this indicator may be a reason to raise an eyebrow, it is probably best to put such concerns as valuations on the back burner. However, it is probably a good idea not to forget about this chart forever either. Remember, in the stock market, things like this don't matter until they do - and then then matter a lot.

Another Reason to Worry: Sentiment Becoming Lopsided

With all the excitement about the Alibaba IPO, which is slated to be the biggest in U.S. history, a fair amount of attention is being paid to emotions and market sentiment. Although the current bull market remains one of the most hated and/or distrusted ever, some the sentiment indicators are also reaching levels that may make you go, hmmmm.

For example, Investors Intelligence takes the temperature of investors on a weekly basis. Respondents are asked to place themselves in either the "bull," "bear," or "expecting a correction" camp.

Savvy investors know to be wary of the crowd at extremes and thus, this is one of the surveys that is closely watched each week. And through the years, paying attention to the crowd at extremes has been quite profitable at times.

The problem is that the current number of "bears" fell to 13.3 percent last week - which is the lowest level since... wait for it... the summer of 1987. Another way to put this is that bearish sentiment is presently at a 27-year low.

Not a Sell Signal, But...

Like valuation indicators, it is vital to recognize that excessive sentiment can remain intact for quite some time. As such, this indicator is not, in and of itself, a reason to run out and sell everything.

However, it is also very important to understand that these types of indicators CAN tell us a thing or two about what to expect from the market in the future.

Sparing the details of the specific indicator, when the number of outright bears in the Investors Intelligence survey has been at or below 13.5, returns over the next three, six, nine and 12 months have been subpar.

Related Link: How Does An Investor's Opinion Affect The Market?

For example, in the past, three months after the number of bears in the II survey hit 13.5 or below, the S&P 500 has produced an average gain of just +0.11 percent. While not a negative number, this is a far cry from the average gain of +1.89 percent for all 3-month periods. And then, twelve months later the story is MUCH worse. Since 1965, the S&P; saw total returns of -0.81 percent after this signal, versus +7.81 percent for all 12-month periods. 

The key takeaway here is that valuation and/or sentiment "issues" are not reasons to buy or sell because those "issues" can (and often do) stay in place for incredibly long periods of time (hence the famous phrase, "the market can stay irrational longer than you can stay solvent"). However, it is definitely worth noting that when extremes in sentiment and/or valuation are reached, future returns tend to be on the disappointing side.

So, while it may be okay to stay long and strong in this type of market, it is probably a good idea to recognize that risk is elevated and that historically, accidents have happened in this type of environment.