The markets seem to get frothier by the day. We have once again reached the point where a down day of half a percent or so is now considered a legitimate “pullback” and brings out the dip buyers in force:

http://www.youtube.com/watch?v=jllJ-HeErjU

Hat tip, Helene Meisler

In our view, investing is about putting the probabilities in your favor: commit capital only when you have a high probability of generating a profit and a low probability of generating a loss. There is some debate about whether stocks at current prices give investors a decent shot at generating profits or not.

erpThe market soared last week when hedge fund star David Tepper made the case that stocks are still extremely cheap. He bases his argument on what’s called the “equity risk premium” which compares the expected future return of stocks to the risk-free rate of return.

Based on this model stocks are currently as cheap as they were at the 2009 and 1974 lows. What strikes us as strange is that these two previous times were marked by extraordinary panic and pessimism towards the stock market. Today one only needs look at the VIX Index, put-to-call ratio or any sentiment survey to see that investors have long forgotten this sort of fear.

Those prior two examples of the equity risk premium being inordinately high also came right at the end of two of the worst bear markets in history. Today stocks are celebrating new highs after gaining roughly 1,000 points since the ominous 666 low the S&P 500 made just over four years ago. So what gives? How can stocks be so dramatically cheap without inspiring any investor despair or suffering an equally dramatic bear market?

The answer, in fact, is quite simple: it’s an illusion, a mirage. Stocks only look cheap in relation to artificially low interest rates which are manipulated by the Fed’s current program of buying over $1 trillion worth each year.

valuationLooking purely at stock market values without regard to artificially low interest rates we see a very different story. Doug Short keeps a comprehensive tally of stock market valuations that he updates each month. It tracks four, independent valuation metrics devised or validated by experts like Robert Shiller and, indeed, the Fed.

According to these models stocks are nearly as expensive as they were at prior major stock market peaks. In fact, stocks are not cheap at all; outside of the internet bubble they are more expensive than almost any other time in history.

What’s more there are many technical signs that this 1,000 point rally for the S&P 500 may be nearing an end. We have noted recently the number of DeMark sell signals that have popped up on various time frames over the past few weeks. Currently, we have a 9-13-9 sell signal for the S&P 500 on the monthly, weekly and daily charts.

hussmanThe coup de grace for the bullish case for stocks, however, was dealt by John Hussman earlier this week. He tweeted a chart that demonstrates the litany of inauspicious indicators that have currently lined up to signal a warning to wary market watchers. They consist of valuation, sentiment and technical measures which ironically include the price performance of the 10-year treasury note, also known as the “risk free rate.”

The prior instances of these indicators lining up this way include the 1972 peak, the 1987 peak, the 2000 peak, the 2007 peak and the 2011 peak. After each of these occurrences stocks sold off to the tune of at least twenty percent. Some of these occurrences, as we well remember, preceded much more painful declines.

Still, the trend for higher stock prices is clearly in place for now. But it seems the trend is the only friend the bulls have right now.

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