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The Most Nagging Question About Stocks

If you constantly find yourself asking when the market is going to crash, you’re a paranoid freak.

You’re not alone, either.

By our best estimates, there are roughly 1.2 million such freaks trading the market each day.

What would happen if all these paranoid maniacs decided to sell?

Well, it’d look a lot like the Hindenburg crash of 1937, which I just happened to watch a documentary about last night.

Look, we’re all human, which means it’s perfectly natural to be a bit paranoid, given that the market keeps hitting new, all-time highs (on what seems like a daily basis).

However, asking about it with no way of arriving at an answer makes no sense at all.

Didn’t you know that only purpose-driven paranoia is productive and acceptable?

To that end, on Wednesday, I introduced you to my trusty “Bear Market Checklist,” which provides a systematic way to assess whether or not anxiety over a stock market collapse is, indeed, warranted.

Full disclosure: I can’t take credit for the checklist. It actually represents a compilation of reliable bear market indicators monitored by myself, along with other noteworthy Wall Street veterans.

Like Richard Bernstein and Morgan Stanley’s (MS) Chief Investment Strategist (and author of the must-read investment book, The Art of Asset Allocation), David Darst.

However, the fact that others find the indicators worthwhile should only boost your confidence in using it.

Now, earlier in the week, I just had time to cover the first four indicators out of nine. Today, I’m finishing the job, so you’ll be fully equipped to answer the most nagging question about the stock market.

Let’s get to it…

Bear Market Warning Sign #5: A Peak in New 52-Week Highs

Bull markets can’t keep rising on the backs of a few stocks. To the contrary, the rally must be broad-based.

It must have “breadth,” as Wall Street pros like to say. And we can easily measure the rally’s breadth by monitoring the number of new 52-week highs.

An early warning sign that a run-up might be losing steam is a declining number of stocks hitting new 52-week highs. As I’ve shared before, Ned Davis Research found that the average bull market ends 30 weeks after the number of new 52-week highs tops out.

So when was the last time this occurred during this bull market? Two weeks ago? Two months ago?

Try two days ago!

As Bespoke Investment Group reports, “An astounding 37.2% of stocks in the S&P 500… hit new 52-week highs [on Wednesday].”

Based on the averages, even if that reading ends up being the tippy top, this bull market could endure until December 11, 2013.

Bear Market Warning Sign #6: Cash Crunch

For stocks to keep hitting new highs, investors need to keep buying more shares. And that takes cash.

But unlike the government, which can simply print more money as needed, individuals can’t. So by monitoring cash balances on the sidelines, we can determine if there’s any fuel left to propel share prices higher – once investors find themselves in the buying mood.

Again, there’s nothing to worry about right now. Although I shared on Monday that investors are rotating out of money market funds into stocks, there’s still plenty more cash to go around.

To be exact, there’s another $2.583 trillion in money market mutual funds, according to the latest tally by the Investment Company Institute.

That’s down about $1.2 trillion since the bull market began. But it’s about $1 trillion more than right before the dot-com collapse. And it’s about $2 trillion more than the lows hit during the early 1990s.

Any way you look at it, there’s more than enough cash to keep fueling this rally.

Bear Market Warning Sign #7: Get Shorty!

The “smart money” has a pretty good track record of increasing their short bets ahead of stock market declines. Therefore, if we’re so overdue for a correction, we should see short interest creeping higher.

Yeah, that’s not happening. Short sellers appear to be borrowing a page from Taylor Swift’s book. They remain completely noncommittal.

The short interest as a percentage of float for the S&P 1500 Index stands at a measly 5.7%. That’s almost exactly where it stood one month ago when I last brought this indicator to your attention. Yet the S&P 500 Index has rallied another 5% since that time.

Bear Market Warning Sign #8: Runaway Valuations

Bull markets give way to bear markets when valuations get overstretched.

Consider: Prior to the dot-com collapse and the Great Recession, the price-to-earnings (P/E) ratio for the S&P 500 Index reached almost 30.

Today, though, it stands a tad over 16. We’re nowhere close to the danger zone.

Not to mention, we’re looking good on a forward P/E ratio basis, too.

As of May 10, the forward P/E ratio stood at 14.2, which is only slightly above the 10-year average of 14.1, according to FactSet.

Bear Market Warning Sign #9: Stocks Can Only Go Up

The time to be wary of a stock market collapse comes when everyone (and their mom) gets bullish and starts buying stocks.

That’s not now.

As Darst says, “Nobody is buying stocks.”

Exaggeration? Maybe a little bit.

But the point remains: We’re nowhere close to a Great Rotation into stocks. There’s no one running around saying that “stocks can only go up” – like they did about real estate not too long ago.

The data backs me up, too…

Take the most recent sentiment readings from the American Association of Individual Investors (AAII), for instance. They’re not even close to being out of whack. The latest bullish sentiment reading checked in at 38.5%, compared to an average reading of 38.8% since 1987.

And the latest bearish sentiment reading clocked in at 29.3%, which is right in line with its long-term average of 30.6%.

Then there’s the STALSTOX Index, which measures the average recommended allocation for stocks by U.S. chief strategists. It’s not overwhelmingly bullish, either. Currently, it rests at 49.2%, down from 61% at the start of 2012.

Bottom line: If you’re prone to worry, I suggest you keep this checklist handy. It’s a much more reliable way of pinpointing exactly when this bull market is losing steam.

Ahead of the tape,

Louis Basenese

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