Four indicators to watch for when rally may be over

Four warning signs

Commentary: Here are four indicators to watch for when rally may be over

By Mark Hulbert, MarketWatch

ANNANDALE, Va. (MarketWatch) -- Is the stock market's rally coming to an end?

Or is this week's churning action merely the pause that refreshes?

The difference between a top trader and the rest of us lies in how these questions are approached. Most of us are merely reactive, getting excited in the wake of any rally and becoming discouraged whenever the market declines -- even when it declines by as little as it did on Thursday, when the Dow Jones Industrial Average(INDU 9,370, +113.59, +1.23%) dropped by just 25 points.

A top trader, in contrast, relies on a set of indicators with proven track records that he or she will have identified in advance. This enables the trader to objectively determine when to sell rather than be vulnerable to emotions in the heat of the moment.

It is with this contrast in mind that I turn once again to Ned Davis, the founder of the institutional research firm Ned Davis Research. I devoted a column a week ago to a discussion of the indicators on which Davis relies to determine whether we are in a secular or a cyclical bull market. ( Read my July 30 column.)

(For those who don't want to take the trouble to click through to that earlier column: Davis concludes that we're in a cyclical bull market.)

In recent days, Davis has turned his attention to what would signal that it was time to reduce equity exposure and go to cash. He mentioned four indicators, any one of which would likely cause him to start selling:

• Valuation. Davis would look to exit from stocks whenever the P/E ratio on the S&P 500's normalized earnings reaches 20. To be sure, putting this indicator into practice is a bit tricky, since it requires normalizing those earnings -- adjusting them, in other words, for where we are in the economic cycle. Nevertheless, Davis calculates that normalized earnings on the S&P 500 index(SPX 1,010, +13.40, +1.34%) currently stand at "around $60," which suggests that Davis will be looking to start exiting the market at the 1,200 level.

• Sentiment. Davis maintains his own sentiment index, which he calls his "Crowd Sentiment Poll." This index currently stands at 62%, according to Davis, which is just above the 61.5% level that he considers to be the lower bound of "extreme optimism." He says that, on past occasions when this index has risen above 61.5%, its eventual peak has averaged 68%. He says that reaching that level this time around would "be a sign for traders to begin selling weak performers."

• Internal market divergences. The indicator that Davis relies on here is one that was created three decades ago by Norman Fosback, who currently edits a newsletter called Fosback's Fund Forecaster. The indicator is called the "High Low Logic Index," which represents the lesser of new 52-week highs or new 52-week lows as a percentage of all issues traded. In Fosback's book "Stock Market Logic," he describes this indicator's rationale as follows: "Under normal conditions, either a substantial number of stocks establish new annual highs or a large number set new lows -- but not both. As the [High Low] Logic Index is the lesser of the two percentages, high readings are therefore difficult to achieve. ... When the Index attains a high level, it indicates that the market is undergoing a period of extreme divergence. ... Such divergence is not usually conducive to future rising stock prices." Fortunately for the current market, this index is solidly in bullish territory right now at 0.8%, according to Davis' calculations. He says that it would have to rise to around 2.5% before he would start looking for the exit signs.

• Rising interest rates. Davis has found from his research that one of the best market timing indicators in recent years has been the 26-week rate of change for investment-grade bond yields. With that rate of change currently standing at minus 12.6%, a sell signal from this indicator is not imminent.

The bottom line? Only one of these four indicators is even close to flashing a warning signal right now, which is why Davis is bullish right now.

But, based on my tracking of his daily hotlines in recent years, I am confident that he won't hesitate to turn neutral or even bearish when these indicators turn.

Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.

From http://www.marketwatch.com/story/four-things-that-will-indicate-rally-may-be-over-2009-08-07