My conclusion is this: the market is fundamentally over-valued and technically overbought (traders and long term investors are overly optimistic). The coupling of these two "environmental" conditions suggest that at least a 12.5% correction (a somewhat arbitrary estimate) is coming our way. Therefore, my short-run target for the S&P is below 990. To capitalize on this movement you may wish to buy slightly out-of-the-money put options on SPX.
The case for fundamental over-valuation:
10 Year Average P/E: 20.31 (vs. historical average of 16.35)
Tobin's Q: .91 (vs. .72 long-run average)
TED Spread: at medium and long run lows
Interest rates at historical lows
According to the below scatter plots, there is a strong correlation between higher P/E and Q ratios and under-performance in terms of annualized returns on the S&P 500. These heightened fundamental ratios both suggest that expectations for earnings are high, and that momentum in earnings growth needs to continue for asset values to rise. Additionally, the reality that long term interest rates and the TED spread remain at very low levels are contrarian fundamental indicators - long term interest rates and short run yield spreads are likely to rise which will lead to even more of an over-valued environment.
Case for over-bought conditions:
Vix: 20.15 (near 52 week low of 16)
Slow Stochastic: above 80
MACD: crested and weakening
Bollinger Bands: very tight and at upper bounds
Volume: very light
200 MA: significantly above ( >13%)
As such, the intersection of so many bullish sentiment indicators (or bearish contrarian) suggest a nearly imminent correction in equity prices.
Scatter plot of 10 yr P/E vs. Subsequent annual return of the S&P
10 Year Treasury Yield
Below: TED Spread
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