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5 Signs You Should Be a Little Worried About the Stock Market

Jun 26, 2017

With the stock market near a record high, investors are feeling pretty good about themselves. And that may be a bad sign.

Last Monday, the Dow hit a new record of 21,528.99. Despite falling back slightly later in the week, it remains within 200 points of that mark. Indeed, data show that, after seven years of steady if not spectacular economic growth, Americans have a rosier outlook than any time since the financial crisis.

That may actually be a problem, say market pros. "Confidence is good to a point. But when it's extreme it becomes a contrarian indicator," says Doug Ramsey, chief investment officer of Leuthold Group, a research and investment firm known or relying on economic data for its investment calls.

History shows stocks do best following periods of investor fear and pessimism -- when those once-fearful investors step back into the market and increase demand for undervalued shares. By the time confidence is widespread, the stock market bargains are usually all gone, leaving little room for more profits -- and often presaging the next bear market.

So where do we stand now? We asked Ramsey to single out five key economic indicators he uses to judge investor and consumer attitudes -- and to reveal when the market may be overheating. Almost across the board, they now indicate a confidence level that is dangerously high.

Of course, that doesn't mean a market crash is around the corner. But it does suggest stocks mightn't have much farther to run before the next correction or until corporate profits catch up with the gains stock prices have already logged.

10-Year Price-to-Earnings Ratio

Source: Yale economist Robert Shiller
Current reading: 30.06 (June 2017)

Perhaps the most common measure of investor confidence is the price-to-earnings ratio, which tracks how "expensive" stocks are -- how many dollars stock investors are willing pay out for every dollar of corporate profits. While many investors simply look at the past year's earnings, that can lead to erratic results. A better method is to look at a "cyclically adjusted" figure, which shows the average over a longer period. Ramsay actually prefers five years, but many investors use a decade -- and 10-year figures are more easily accessible on the Web, tracked by Nobel economist Robert Shiller.

Just how high is today's reading? Higher than at any time in the past 130 years, except the just before the Great Depression and during the late 1990s tech bubble.

Consumer Confidence Index

Source: Conference Board
Current reading: 117.9 (May 2017)

Based on a monthly survey of U.S. households by Nielsen -- yes, the same people who publish television ratings -- the Conference Board's Consumer Confidence Index measures how everyday Americans feel about their current economic situation, and what they expect in the future.

As explained above, however, consumer confidence is typically a 'contrarian' indicator when it comes to stocks. Calculated since 1985, readings below 60 indicate pervasive worry, while those above 100 show high spirits, according to Ramsey -- and are therefore should give you pause.

'Misery Index'

Source: Federal Reserve Economic Data and Bureau of Labor Statistics
Current reading: 6.2 (May 2017)

The so-called "misery index" was invented by a former Johnson White House economic advisor, Arthur Okun, in the 1970s to offer politicians a fast and dirty way to judge the health of the economy. You have to calculate this number yourself, but the method is pretty simple: Take the civilian unemployment rate (4.3% today) and inflation (1.9%) and add them together.

From an investor's perspective, it's another contrarian indicator: An unusually low Misery Index score often indicates a bull market has run its course. Indeed, the Misery Index hit 6.7 in December 1999, shortly before the tech bubble burst, and 6.5 in August 2007, ahead of the financial crisis.

Exposure Index

Source: National Association of Active Investment Managers
Current reading: 92.61 (June 21, 2017)

The weekly NAAIM survey is designed to show how bullish professional investors are about stocks. The score -- 92.61 last week -- is supposed to represent the percentage of these pros' investment portfolios currently invested in stocks. In other words NAAIM members are currently telling the organization they have more than 90% of their money in the stock market, and only about 7% held back in cash or some other type of defensive investment.

In theory, the NAAIM index can range from -200 (meaning managers are betting against the market) to +200 (meaning managers are investing all their money, plus extra money they have borrowed.) More normally, says Ramsey, readings of 10 or below indicate excessive pessimism, and readings above 90 or 95 indicate excessive optimism -- a sign that a pullback could be due.

Equity Put/Call Ratio

Source: Chicago Board of Options Exchange
Current reading: 0.69 (for the week preceding June 19, 2017)

Ramsey calls this his "desert island" indicator -- meaning it's the one he'd hang onto if he could only keep one. A "put" is a way of making a bearish bet; specifically, it's a type of stock option that gives the investor the right to sell shares at a set price for a set period of time. A "call" option is its bullish counterpart. The lower the ratio, therefore, the more bullish (i.e., more confident) investors are.

A week ago, the CBOE reported that investors held 3,094,843 bearish put options compared to 4,449,244 bullish call options, for a ratio of 0.69 -- which Ramsay regards as "moderately bullish." By contrast, he says, a 0.5 ratio would indicate even more optimism, while a ratio of 1 would show excessive fear.

One reason Ramsey especially likes the CBOE number: Unlike questionnaires, it reflects actual bets made by investors. "It's hard money," he says.

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