Sierra Investments: Stocks are overvalued in the U.S. by 25%

The following is taken from Sierra Investment Management’s latest market outlook called, “A Subdued Recovery: Recent Trends in the U.S. Economy”. To read the full report, click here.

In looking ahead, our greatest concern for the next twelve months, now that the liquidity problems of the large European banks has been resolved as well as near-term sovereign debt problems, is an exogenous shock of some type. Thus, we have moved from the “known unknowns” to the “unknown unknowns”. There are, of course, worries about hostilities with Iran, including the security of the Gulf of Hormuz; normal concerns about drought and other weather disturbances, but even more important is the potential for a successful terrorist attack, the collapse of governments in Afghanistan or Pakistan, or renewed sectarian warfare in Iraq.

We believe that stocks are overvalued in the U.S. by 25% or more and that at least part of the recent stock rally was a “sugar high” from the massive creation of cash by the ECB and other institutions over the past four months, as well as some further monetary ease by the Federal Reserve. The effects of this will wear off rather soon, we think, and a correction of some magnitude will probably begin within the weeks ahead, which could extend into a cyclical decline similar to the two previous cyclical bear markets of the current century.

Among many potential red flags for the stock market we note that the peak in the profit cycle is now behind us and that the S&P has faced large corrections every time Wall Street analyst estimates have moved above $100 EPS for the S&P. Elsewhere, NASDAQ appears to have gotten way ahead of itself, while the Dow Transports peaked more than a month ago and are off their highs quite in the last few weeks.

Technically, the recent rally seems to have topped with the majority of the S&P 500 stocks trading well below their ten-day moving averages. Volume has been very weak, as has breadth in recent weeks. Sentiment as tracked by Investors Intelligence also shows very high percentages of Bulls relative to Bears, with the four-week moving average of Bulls minus Bears near the upper .65 region that has generally been characteristic of an over-exuberant stock market climate.

In light of all these factors, Sierra continues to remain generally cautious on the big picture, but has nevertheless added several low volatility “risk asset” allocations into our portfolios. These include positions in high-yield corporate bonds, master limited partnerships and emerging market debt. Other categories where we continue to accrue attractive Total Returns include high-yield municipals and high-grade corporate bonds.