Irrational Exuberance Part III ?

Federal Reserve Chairman Alan Greenspan used the words "irrational exuberance" in a speech to the American Enterprise Institute on December 5th, December 1996:

"Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?"

Robert Shiller, the latest winner of the Nobel Prize in Economics, then used the same words as the title of his well timed book as published in 2000 following one of the all-time greatest stock market tops in U.S. history.

In early 2000 when the "Dot Com" bubble started to burst, the Nasdaq Composite peaked in March at 5132 and then proceeded to fall nearly 80% to its final low at 1108 in October 2002. Over the same time period the S&P 500 Index plunged 50% from 1553 to 769.

In valuation terms, how does today's U.S. stock market compare to the market in March 2000? Always tough to make these kind of comparisons, but the Shiller 10-year Cyclically Adjusted Price Earnings (CAPE) ratio might be a useful tool here. The mean value for this ratio over the last 150 years has been 16.50. Let's call this "fair value" for the S&P 500 Index. The record low was posted in December 1920 at 4.78, while the record high was set in December 1999 at 44.20. The current CAPE ratio is 26.30, which means that the S&P 500 Index is about 59% overvalued right now. For historical reference, the Shiller CAPE ratio traded near 30.00 in late October 1929 just before that market crashed.

Attached is the latest Investors Intelligence sentiment survey which shows 59.6% bulls and 14.1% bears. The ratio of bulls to bears at 4.23 : 1 may not be the highest in history, but it's the highest I've ever seen. The latest AAII sentiment survey shows 55.1% bulls and 18.5% bears. I've seen a greater spread here a few times, but not many. Of course, if you believe in "contrary indicators", then these two surveys alone will have you more than a bit nervous with any long stock positions.

Like many stock market technicians, I love the abundance of free stock screening software now available. My favorite is located on www.finviz.com where I have developed two simple screens to find potentially "undervalued" and "overvalued" stocks. Both screens were designed to reduce the set of 6,500 listed stocks to less than 50 that meet certain criteria. From there I could then research each individual stock to see if an investment is warranted. While each of my two screens has at least six criteria, the backbone of my overvalued screen is the simple test that the "Forward Price / Earnings Ratio be greater than 25". For the undervalued screen, the Forward P/E must be less than 15. All the other criteria are important, of course, but the "Forward P/E" variable is the over-riding consideration in both my screens.

Last year at this time, my undervalued screen produced 17 stocks. Now there are just 2 names on this list. For the overvalued screen, last year at this time there were 39 stocks on this list. Now there are 165 names, a record high number of overvalued stocks from my simple overvalued stock screen. Of these 165 names, 24 are currently trading at more than 100 times 12-month forward earnings estimates. And 33 of these 165 stocks are actually trading at greater than 10 times trailing twelve month sales! These are incredible numbers!!

After my simple screens generate their overvalued and undervalued stock lists, I then perform a second level of algorithms to further dissect and rank the stocks on each list. For those that are curious, here is my current list of "The 25 Most Overvalued U.S. Stocks" as of Friday's close, December 27th:

Bottom Line: The U.S. Stock Market is now in the final days of a "record setting bubble" that is about to burst. There are too many bulls among often-wrong trading groups. Dangerous leverage, as measured by investor margin debt, is now at a record high. Valuation measures like the Shiller Cyclically Adjusted Price/Earnings Ratio (10-year at 26.30) are now screaming "sell everything". The Federal Reserve has already announced its intention to scale back monthly purchases of Treasury securities and Mortgage-back Obligations. The 10-year Treasury yield is now above 3.00%, having risen from 1.61% in May 2013 and a low at 1.39% in July 2012. While monetary policy must still be considered "accommodating", it is clearly less so now than a year ago. It seems to me that all the best possible news on corporate earnings, fiscal and monetary policy, and even prospects for the global economy are all fully factored into current stock prices. In the interest of full disclosure, I am long Gold/Silver mining shares and short the S&P 500 in the accounts that I manage. Is that a Black Swan I see on the horizon?

Courtesy: Yardeni Research, Inc. (www.yardeni.com)