US Markets Valuation, Sentiment and Technical Analysis - January 2012

In recent weeks, the S&P 500 has performed very well, almost reaching 2011 highs. At the same time, several indicators would seem to indicate a recession is coming to the US in 2012 and the Baltic dry Index does not look good either.

Today, I'm going to look at US markets, both in terms of valuation and sentiment. I will also look into technical factors to help determine whether it is a good time to sell or even short US markets.

S&P 500 Valuation.

For long term investors, Shiller S&P 500 CAPE (10-year price earning ratio adjusted for inflation) is the reference to assess whether the S&P 500 is undervalued or overvalued. Here's what it looks like today:

 The CAPE stands at 21.14, it's much lower than the CAPE in 2000 (That is when Shiller talked about "irrational exuberance"), but still high compared to historical CAPE (average is around 15-16).

Another way, I like to look at valuation is by looking at earnings only. Historically, they've had a tendency to increase at a fix rate over long period of time and always oscillate around the trend line. That's the "mean reversion" preached by Jeremy Grantham. Here's the logarithmic chart of S&P 500 inflation-adjusted earnings between 1870 and 2012.

In 2011, earnings are above average and will revert to the mean at some point. Of course this could be this year or in several years.

Based on the 2 metrics above, it seems that based on valuation it is rather risky to invest in the S&P 500 or at least it's likely to average disappointing returns.

US Market Investors Sentiment.

Previously I liked to follow Market Harmonics Bull/Bear ratio, but it is not a free service anymore since last April. Now, I use the AAII sentiment index instead:
 Week ending 1/25/2012

Bullish	48.4% up 1.2
Neutral	32.7% up 3.5
Bearish	18.9% down 4.7

According the AAII, the long term average are as follows: Bullish: 39%,  Neutral: 31% and  Bearish: 30%.

That shows people are now pretty optimist about the future. As a contrarian, that would be a bearish sign.

However, I like to look at things in a longer term perspective using AAII-14, as explained in my post "Using AAII Sentiment Survey to Time the Market". If the 14-week moving average of the AAII "Bullish" sentiment index is at 30% or below is a long term buy, above 50% it is a long term sell.

Now the AAII-14 is at about 42%, so this is neutral.

S&P 500 Technicals.

I'm now going to look at my 2 favorites technical metrics the RSI-14 and the index showing the percentage of stocks above their 200-day moving average (NYA200R).


I use the 14-day relative strength index moving average for short term moves.

The S&P 500 6-month chart and RSI-14 chart (Source: Yahoo Finance) shows it is now at 76.20. On the 23rd of January the RSI-14 was at 87.57 which was overbought, so a short term correction should be expected.

The NYA200R is really the index which tell me "wait" when other indicators tell me to buy or sell. Here's what it looks like today. (Source: StockCharts.com)

At 65.10%, the NYA200R tells me there is probably more upside potential for the S&P 500. I would become wary of holding stocks if it reached 80% or more for several weeks/month.

Conclusion

As some indicators suggest, there are significant recession risks for 2012. The S&P 500 seems relatively overvalued compared to historical ratios. Short term investors are very bullish and the market is overbought. However, longer term, it appears we have to not reached extreme bullishness (as the AAII-14 implies) and the NYA200R would suggest stocks have still more upside.

Based on this analysis, I would personally not add any position at the moment because of valuation and short-term bullishness and would even consider decreasing exposure to US stocks. I would not short the market however, because not all indicators are extreme and we have mad men (e.g. Ben Bernanke) and women (e.g. Janet Yellen) at the head of the US federal reserve that could unleash QE3 after announcing zero interest rates until 2014 since week.