Introduction

I don’t have an official definition of a market bubble, but we can probably all agree on this: stock prices are currently divergent not only from the economy but from the underlying market fundamentals. So if you think the current stock run is justified, then you likely believe that stocks are forecasting better growth in the economy or market fundamentals (i.e., earnings) will improve or that there will be some catalyst that justifies the price ramp. The best and most easily identifiable catalyst has been Federal Reserve largesse, and this has done little for the economy. In addition, market intervention has distorted normal market signals. Federal Reserve policy doesn’t improve investment in the real economy but rather diverts investment capital away from the economy and into risky assets. Like so many things about the years since the financial crisis, it creates the illusion of wealth without a sound underpinning. I have no doubt that keeping interest rates artificially low has a positive effect on those sectors of the economy that are interest rate sensitive, but all this does is pull demand forward like the “cash for clunkers” program. Is there demand for homes because wages and salaries are growing or because interest rates are a great deal? I would argue that it is the latter. It just doesn’t seem intuitively correct that you can print your way to prosperity.

Getting back to the stock market, the biggest bubble is in investors’ belief that there is no risk. This too is mis-guided because anything worth attaining always entails risk. We are not in a new paradigm or investing nirvana nor should we kid ourselves that the stock market is forecasting better economic times ahead. How good was the market’s last forecast at the 2007/ 2008 highs? The market is going up because investors believe that the shit will never hit the fan. It is a mania or fad in and of itself. This too shall pass.

We became bullish 13 weeks ago when investors turned bearish on equities. It is our expectation that this trade should last on average 15 weeks. The best, most accelerated gains typically occur in the beginning of the trade. Just when investors typically get the all clear, the trend will flatten out. I suspect we are in this phase of the trade. Our plan is to become sellers of equities when investor sentiment unwinds, but we are not at that point, and I doubt we will be there until 2014 as the calendar is on the bulls’ side. Investors continue to pile into the markets; corporate insiders are selling. This is never a good recipe for a sustainable price move. This probably won’t end well as we know how this story will play out, but that tale will likely have to wait until 2014.

As a reminder, we have moved our stop loss up to SP500 1706.92.

To see more on investor sentiment including charts on the Rydex Asset Data and the $VIX, visit TACTICAL-BETA. WE ARE 100% FREE!!!

The Sentimeter

Figure 1 is our composite sentiment indicator. This is the data behind the “Sentimeter”. This is our most comprehensive equity market sentiment indicator, and it is constructed from 10 different variables that assess investor sentiment and behavior. It utilizes opinion data (i.e., Investors Intelligence) as well as asset data and money flows (i.e., Rydex and insider buying). The indicator goes back to 2004. (Editor’s note: Subscribers to the TacticalBeta Gold Service have this data available for download.) This composite sentiment indicator moved to its most extreme position 10 weeks ago, and prior extremes since the 2009 are noted with the pink vertical bars. The March, 2010, February, 2011, and February, 2012 signals were spot on — warning of a market top. The November, 2010 and December, 2012 signals were failures in the sense that prices continued significantly higher. The current reading is neutral but heading towards bearish (as in too many bullish investors).

Figure 1. The Sentimeter

Dumb Money/ Smart Money

The “Dumb Money” indicator (see figure 2) looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investors Intelligence; 2) MarketVane; 3) American Association of Individual Investors; and 4) the put call ratio. The indicator shows that investors are extremely bullish.

Figure 2. The “Dumb Money”

Figure 3 is a weekly chart of the SP500 with the InsiderScore “entire market” value in the lower panel. From the InsiderScore weekly report: “A Strong Sell Bias continues market-wide as sellers outpace buyers by a wide margin. Transactional volume was more limited this past week due to the Thanksgiving holiday but there was little change in insiders’ behavior. The Consumer Discretionary, Technology, Industrial Goods and Materials sector are each showing Strong Sell Biases, followed by Energy, Financial and Healthcare with Sell Biases, and Utilities, Consumer Staples and Utilities, where sentiment is Neutral. Elevated levels of market-wide selling should not be dismissed, but we note that given the market backdrop — the S&P 500 hitting a new all-time high last Friday and the NASDAQ Composite breaching 4,000 for the first time since September 2000 — the sentiment being displayed by insiders is not surprising. “

Figure 3. InsiderScore “Entire Market” value/ weekly