Sunday, October 6, 2013

Indicators Give Overbought Signals

 Subscribe in a reader

Each month, the New York Stock Exchange (NYSE) releases data on the customers of clearing firms overseen by the NYSE. This data includes that of margin debt and free credit balances. NYXdata website

The value of credit balances, which represents free credit in investor cash accounts, plus credit balances in margin accounts, less margin debt. Net credit balances can be positive or negative.

 When credit balances are positive, investors have surplus cash to invest, or dry powder.  Extreme negative credit balances mean investors are significantly overextended, suggesting that investors are “irrationally exuberant.”  The most extreme negative credit balance levels observed in 2000 and 2007 coincided almost exactly with cyclical market tops, which preceded periods of devastating losses for equity investors.

One has to ask if the markets are now approaching a cyclical top?

The first chart shows the percentage growth of the two data series from the same 1995 starting date, again based on real (inflation-adjusted) data. Over the 250% level raises a warning flag, the market even by Warren Buffett's standards is fairly valued link

Investors are overextended and leverage has hit levels not seen since the 2000 tech bubble.  Equity prices and earnings have recently diverged (negatively), the S&P 500 price-to-sales ratio has climbed to extreme levels, and sales growth has stalled.  The market is overbought (long-term not short-term), overvalued and investors are overextended.  Does this mean the market cannot continue to climb higher?  Of course not.  All experienced traders know the market can stay irrational longer than we can stay solvent.

However, for prices to continue to advance, the market must become more overbought, more overvalued, and investors must become even more overextended.  In the current environment, the odds are clearly stacked against equities and the risk of a pullback is elevated.

Margin Debt:  Provided they are approved to do so, a customer may borrow funds from a brokerage firm.  The brokerage firm will not do this unless the customer has existing collateral (i.e. stocks) in the account against which the customer can borrow.
Free Credit:  When a customer sells stock in a margin account (or a cash account), they are considered to have a free credit.  This is essentially just another name for cash.
Available Cash:  The difference between free credit balances in cash and margin accounts and debit balances.  Customer accounts can be thought of as a balance sheet, with liabilities (margin debt) and assets (free credit balances). 

Granted, the above charts are compelling and raise a caution flag, however this is just on measure. ITZ asked, what about Price Earnings (PE) for the S&P500?

Is the market over valued here? 

Here is a new update of a popular market valuation method using the most recent Standard & Poor's "as reported" earnings and earnings estimates and the index monthly averages of daily closes for the past month. PE10


No comments: