Signs of stock market top

There are currently quite a few signs that we are near stock market top:

1. Excessive valuation

The stock market valuation is above the historical norm. Q ratio is second highest in history. Shiller PE is over 27. When the market turns, the value conscious investors will stay away.

2.  Extreme bullishness

Even minor market dips are heavily bought. Cash allocations are low. Margin debt is high. Investor sentiment is extreme.

3. Final push/overshoot

Everyone wants to buy in a fear of missing out and no-one wants to sell. This can result in a final rapid price appreciation that stands out and makes the overvaluation just more obvious. Think about climbers reaching a summit and asking "now what?". The 10%+ price run a matter of weeks qualify as significant movement. 

4. Deterioration of market breath 

Healthy market moves in unison. Strong bullish tide carries all stocks. When this starts breaking down (more stocks making new lows, more stocks below long term moving averages), the market is about the hit an air pocket.

5. Rolling over of leading indicators

The unprecedented monetary stimulus has made leading indicators less useful in this business cycle. The current expansion is one of the longest and weakest. Looking OECD indicators, the global growth is continuously weak, near the stall speed. The US based private research company ECRI's weakly leading index growth is also negative.

6. Widening of credit spread

The credit spread, difference between high yield and treasury bonds is on the rise signaling risk aversion. This correlates well with stock market.

7. Money flows into defensive stocks (utilities and consumer staples)

This is the classical market timing method. The current bull market is a bit confused but utilities and consumer staples have been the strongest performers indicating defensive stance.

8. Increasing volatility and "nervousness"

Small daily movements become wider daily swings. The market leaders suddenly hit air pockets. Apple losing 5% intra day qualifies.

9. Emperor has no clothing moment

A wide spread recognition that something everyone already knows may actually matter. For example, everyone know in 2000 that valuation was high. Then suddenly PE>150 actually mattered. For example, housing bubble in 2008 was obvious but it did not matter as housing never went down. Until it did. Currently, everyone knows stock market is a bubble but it does not matter because of central banks. But suddenly this will change and everyone will know that everyone knows that this is a bubble.

In summary, all the ingredients for market top are in place. All that is missing is the "emperor has no clothing" moment. 

Using Topin's q to estimate future stock market return

Tobin's q is the ratio between a physical asset's market value and its replacement value. We can use Tobin's q gauge to value of stock market relative to its replacement cost:

q = (value of stock market) / (replacement cost)

Or written differently

q = P/B

where P is the price all the stocks of all the companies and B is the book price of what it would cost if we were to build the companies from scratch. In essence, q is a measurement of stock market valuation relative to their assets.

Figure 1 shows historical q for U.S. corporations. It has varied widely over time depending on business cycle, inflation expectations, and most importantly, the investor sentiment. The average q = 0.71 indicating that historically the corporations have traded below their replacement value. Currently q = 1.1 which is historically high. Only during the internet bubble years has Topin's q been higher.

Figure 1: The U.S. stock market Tobin's q.

Valuation is not a good indicator for near term market movement but it can be used to estimate longer term stock market returns. Over several years, the valuation metrics tend to revert to to long term mean. We can use this fact to estimate the future stock market return by writing the price N years into the future as

Here qAVE is the historical average q, qNOW is the current q value, g is the average growth rate for the assets, and PNOW is the current stock valuation (Geek note: derivation at the end of this article). Note that this relationship does not account for dividends.

Figure 2 shows the modeled annualized stock market returns and actual realized returns over the 7 year time span. The plot does not account for dividends and is not adjusted for inflation. Currently, the projected return is negative. With dividends included, the nominal 7 year return is about break even meaning that one could just hold the cash and avoid the stock market risk.

Figure 2: The stock market return estimate based on Tobin's q ratio.

APPENDIX: The derivation between the current stock market price and future price estimate using q ratio: