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3 signs that a stock crash is coming
Three major indicators with strong track records are signaling it’s time to sell stocks. Here’s how they work and why investors should worry.

By Michael Brush
What a great time to own stocks.

The Dow Jones Industrial Average ($INDU) is setting records just about every day. The S&P 500 Index ($INX) has advanced 12% in less than five months. Technology stocks are up about 14% since midsummer.

The giddy stock bulls may be in for a nasty surprise. They’re ignoring three trusty stock-market indicators — with great records for predicting corrections — that currently are saying it’s time to get out of equities. The signals are closely watched by market technicians on the lookout for hints that the bull run is getting tired.

One of the indicators says stocks are simply expensive compared with other investment options available to big money managers. Another says that mutual fund managers have mostly exhausted the supply of dollars they have available to put into the market. And the third says that the smartest investors are now betting on a downturn. Together, these harbingers paint a far different picture of the market than do the raw return numbers.

Here’s a closer look at these indicators and why you should be cautious with stocks now.

The stock-bond trade-off
Money managers chiefly put money in two assets: stocks and bonds. One way of deciding whether stocks are expensive is by comparing their performance to that of bonds. If bonds lag while stocks advance, according to some market watchers, fund managers will be more likely to sell stocks and buy bonds.

But how do you compare the prices of stocks to bonds? Jason Goepfert of SentimenTrader.com looks at the performance of the largest bond and stock indexes as they are embodied by two exchange-traded mutual funds — the Standard & Poor’s Depositary Receipts (SPY, news, msgs), which tracks the S&P 500 Index, and the iShares Lehman 20+ Year Treasury Bond Fund (TLT, news, msgs), which tracks 20-year government bonds. (For data that predates the funds, he compares the S&P 500 with the 10-year Treasury bond.)

To compare them, Goepfert contrasts the current ratio of the SPY to the TLT with the average ratio over the past three months. Since the ratio typically doesn’t change much in 90 days, the two values should be about the same. Now, though, with the recent rally in stocks, there’s a big gap. The current ratio has moved up to 1.58, compared with an average of 1.5 over the past 90 days. That may not sound like much. But since the ratio usually stays fairly constant in any 90-day period, this is a huge move compared with what normally happens.

The difference between the current gap and the 90-day average is at a level seen only 1% of the time. (For you statistical wonks, the indexes are now more than three standard deviations away from the norm). “Stocks are rarely as overvalued to bonds as they are now,” says Goepfert.

In the three months after such an extreme reading, the performance of the S&P 500 has ranged from a loss of 8.7% to a gain of just 1.7%. That’s a bad outlook for the bulls. It gets worse: This indicator has called two of the biggest market declines in the past decade.

It flashed red just before the big correction that started in March 2000, signaling the end of the technology bubble. By the end of 2002, the S&P 500 had fallen more than 45%. (On the upside, this model said buy in mid-2002, just before the start of the current bull rally.)

On July 17, 1998, the model said sell just before a dramatic crash that took the S&P 500 down 19% in the next month and a half. On Aug. 31 that year, the model said buy just before a September rally that took the market up 11% in a month.

Cash-strapped mutual funds
Mutual funds are allowed to hold cash instead of stocks or bonds. How much cash they have on hand is often a good signal of where the market is heading. If they have a lot of cash, it means there’s still a lot of money left to go into stocks. When cash levels are low, it means there’s less money on the sidelines to drive stocks higher. It also means that if retail investors get scared and sell their fund shares, fund managers will have to sell stock to meet redemptions, driving stock prices lower.

As of the end of August, U.S. equity mutual funds had 4.4% of their assets in cash, according to the Investment Company Institute. Goepfert adjusts this number for how much cash they should have on hand given the current level of interest rates. Even though interest rates are relatively low, Goepfert figures that funds should have a 7% cash position, according to historical trends. This means funds have 2.5% less cash than they “should” have, given the level of short-term interest rates. This is another historic extreme.

Since 1950, whenever cash shortfalls hit these lows, the S&P 500 has fallen 69% of the time with an average decline of 4%. Ominously, the last two times cash levels were this low, bad things happened to stocks. Cash levels hit these lows in early 2000 just ahead of the last big bear market. Cash also hit current levels in early 1981 just before a two-year market slump.

The smart money is bearish
Investors, of course, always want to know what the “smart money” is doing. To figure this out, Goepfert turns to the Commodity Futures Trading Commission.

First, a primer on futures contracts. Traders who own futures contracts on a stock index like the S&P 500 have purchased the S&P 500 stocks at a price agreed upon now, for delivery at some point in the future. Usually these contracts are settled in cash, without delivery of the underlying stocks.

To keep track of the futures markets, the CFTC makes brokers report client positions. The CFTC designates the biggest traders — those holding more than 1,000 S&P 500 futures contracts — as “commercial” traders. They only make the grade if they hold those futures contracts as a part of a hedge to protect against losses in underlying investment positions. Goepfert considers these commercial traders to be the “smart money.” (The other two categories are big speculators, who hold 1,000 or more S&P 500 futures contracts that aren’t part of a hedged position, and small speculators, who hold less than 1,000 contracts.)

Right now, commercial traders have a $30 billion net short position in futures on the S&P 500, the Dow Jones Industrial Average and the Nasdaq Composite Index ($COMPX). Going short is a bet against the market. Traders go short by borrowing securities and selling them, hoping they will be able to replace them later at a cheaper price after a market decline.

This is only the third time in recent history that this short position has been so large. The other two times were early 2001, just before the S&P 500 tumbled 38%, and November 2004, after which the market rose some more and then corrected in early 2005.

A ray of sunshine
Taken together, these three indicators say its time to be more cautious with stocks — but they don’t mean that a sharp correction is 100% certain.

Here’s just one dissenting voice: Robert Froehlich, chairman of the investor strategy committee at DWS Scudder, the U.S. mutual fund division of Deutsche Bank. Froehlich points out we are moving into the seasonally bullish phase for stocks. This is the six months from early November to the end of April, a period Froehlich calls “turkey to tax time.” Since 1950, the average return of the S&P 500 during this phase has been 9%. The average return of the S&P 500 during the other six months of the year was only 2.71%.

At the time of publication, Michael Brush did not own or control any of the equities mentioned in this portfolio.