5 Signs the Market Is Topping Out

Source: Thinkstock

Source: Thinkstock

With the stock market at all time highs, investor are relatively optimistic that its ascent will continue. The S&P 500 sits just below 1,900 and the Dow Jones Industrial Average is just below 17,000, and analysts are throwing out targets of 2,000 for the S&P 500 and even 20,000 for the Dow. It seems that investors have forgotten that just five short years ago the S&P 500 was trading at 700 while analysts were calling for a 400 price target.

With sentiment having turned so positive after being so negative, I think it is time for investors to start looking for selling opportunities in many stocks. That isn’t to say you should sell all of your stocks today and sit in cash, but you should locate the companies in your portfolio that are trading at lofty valuations, and whose futures analysts are overly optimistic about. There are five reasons for this.

1. Stocks are trading with historically high price-to-earnings multiples

Over the past several decades, stocks have traded within a very wide range of price to earnings multiples. They have exceeded 40 at one point during the peak of the tech bubble, and yet stocks have traded at 6 times earnings back in 1948. Right now, stocks trade at about 22 times trailing earnings, and with slowing growth rates for corporate profits, the forward P/E ratio isn’t much lower. Could they trade up to 40-times earnings? It is certainly possible. However, historically, it has been a good idea to sell stocks when their price-to-earnings multiple exceeds 20 and to buy them when their price-to-earnings multiple is less than 10.

Source: Thinkstock

Source: Thinkstock

2. Dividend yields are historically low

Like with price-to-earnings ratios, dividend yields on the S&P 500 have fluctuated wildly. The aggregate dividend yield of the S&P 500 exceeded 10 percent during the Great Depression, and during the tech bubble it was lower than the 1.8 percent rate of today. Historically, stocks have been a strong long-term “buy” when dividend yields have exceeded 6 percent, and they have been a “sell” when they dipped below 3 percent. Now some may retort that dividend yields don’t matter because companies are buying back stock in lieu of dividends. But keep in mind that a company will raise its dividend when it is very confident that it can sustain this dividend. Stock buybacks are often made with excess capital, and management’s judgment regarding the over or undervaluation of its own stock is heavily biased, and unless the company is substantially undervalued or has had a strong history of successfully reducing the number of shares outstanding at opportune times it should stick with dividends.

Source: Thinkstock

Source: Thinkstock

3. The Federal Reserve is tapering

If we look at the history of the Federal Reserve’s quantitative easing programs, it is clear that the market started to correct when stimulus was removed. This happened twice — in 2010 and in 2011. The Fed is still stimulating and the market is, not surprisingly, moving higher as a result. But the rate of ascend has declined along with the taper, and I suspect that if the Fed follows through with the total removal of its stimulus program that the stock market will fall.

Source: Getty Images

Source: Getty Images

4. Investors are irrationally bullish on extremely overvalued stocks

A good way to tell that sentiment has reached an extreme point one way or another is to look at sentiment for market darlings. These are stocks that investors feel that they must own even if they are clearly overvalued by any historical measure. Some of these names include:

When analysts are suggesting you buy these names at 50 or 100 times earnings, there is a disconnect between sentiment and fundamentals, which suggest that such rapid growth cannot continue indefinitely, and that stocks trading with such absurd price to earnings multiples need to trade substantially lower.

Source: Thinkstock

Source: Thinkstock

5. Margin debt is at an all time high

When investors are positive, they want to own more stock than they can afford. This means they borrow money to buy stock, or buy stock on margin. Right now, margin debt sits at about $450 billion, which is higher than the 2007 peak. With all of this margin debt outstanding, we can deduce that those who are bullish of stocks already own the amount that they can afford and then some. Furthermore, while stock bought using cash can simply be held indefinitely, stock bought using margin eventually has to be sold or the account has to be re-funded in order to pay off the debt. This means that there is a build-up of potential selling. While margin debt can rise higher, especially with interest rates so low, the fact that it is so high shows a lot of enthusiasm, and this is a sell signal.

Disclosure: Ben Kramer-Miller has no position in any of the stocks mentioned in this article.

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