When does overvaluation matter?

• High valuations lead to large stock market declines during recessions.
• During secular bull markets, modest overvaluation does not produce large stock market declines.
• During secular bear markets, modest overvaluation still produces large stock market declines.

Using shorter term time frames, what matters more to stock prices is macro-economic and earnings momentum. Macro Man recently created a simple model that regressed retail sales, industrial production and durable goods, ex-transportation, to the stock market. The fit is remarkably good.

This got Macro Man to thinking.   Retail sales, like the SPX, are very comfortably above pre-crisis highs, IP is marginally so, and orders are basically at the level.   What would happen if we regressed these 3 series against the SPX?  The results are set out in the chart below.

To mitigate the impact of leverage, Macro Man ran the same regression, but on the natural log of the SPX to smooth the swings in stocks relative to the economy.  Upon obtaining model output, it was a trivial matter to reconvert the data back into SPX terms.  The results of this study are below.

Here is what we will need to see in the data to confirm a change in market trend has commenced:

1. More new lows than new highs
2. New low daily readings registering triple digit figures, consistently
3. The NH-NL differential must turn negative
4. The 10-d and 30-d average differentials must go negative (this is essentially the first sure sign that the market is changing direction – especially the 30-d diff.).
5. Differential readings start registering figures larger than -300, -400, -500+.

March 2013 NH-NL Readings for NYSE:

1. NYSE New Highs: The number of stocks making New Highs on a specific date
2. NYSE New Lows: The number of stocks making New Lows on a specific date
3. New High –New Low Differential: This is simply the number of stocks making new highs minus the number of stocks making new lows.
4. NH-NL 10d Diff: This is a simple 10-day moving average representing the number of stocks making new highs minus the number of stocks making new lows.
5. NH-NL 30d Diff: This is a simple 30-day moving average representing the number of stocks making new highs minus the number of stocks making new lows.
6. NH-NL % Ratio: To calculate the percentage correctly, use this formula: (New Highs – New Lows) / (New Highs + New Lows) * 100 = X%
7. NH-NL % Ratio 10d Ave: This is a simple 10-day moving average representing the percentages listed in the column terms #6 in this list

• It can take many months for the top to form.  In 2007 it took 10 months.  the 30wk MA and 40wk MA were broken and the market could not recover them.