At first glance, fool's gold cannot be distinguished from real gold. Even at second or third glance, novices are not able to discern the difference. To avoid getting fooled, miners have come up with the acid test.
Most metals tend to bubble or fizzle when they come into contact with acid, precious metals don't. Placing a small drop of a strong acid, such as nitric acid, onto the metals surface quickly and unmistakable differentiates real gold from fool's gold.
Is there a time-tested method to distinguish a bulls market from a 'fools market?' Is the market 'bubbling' right now (two-fold meaning of bubbling intended)?
A thorough acid test for stocks involves a short-term and long-term analysis. If you are dealing with the birth of a new multi-year bull market, the short-term movements of course are less significant, but still they provide valuable insight.
Short-term acid test
One of the most basic indicators of technical analysis is trading volume. Just as the number of fans your favorite football or baseball team draws, reflects the amount of support, trading volume is indicative of the conviction behind the move.
The fingerprint of a healthy bull market is high volume on up days and low volume on down days. The past several months have delivered exactly the opposite with overall trading volume 30 - 40% below the previous decade's average. To make matters worse, volume on up days has been about one third less than volume on down days.
Volume is no short-term indicator, but the evidence seen over the past six months shows clearly that there is no conviction behind higher prices.
Other short-term indicators such as momentum and pivot points do allow for higher prices. Pivot points outline a trading range with support and resistance points based on previous trading sessions and can be calculated for any period of time from hourly to monthly.
Pivot points can be applied to broad market indexes such as the Dow Jones, S&P and Nasdaq, sector ETFs such as financials, technology, consumer discretionary, consumer staples or individual stocks.
When the index in question, let's take the S&P 500, trades above the pivot or mid-point, it is likely to trade the day between pivot and resistance. If it is below the pivot, it is likely to trade between pivot and support. The accuracy ratio over the past months has been 70% or higher. The ETF Profit Strategy Newsletter provides weekly and monthly pivot forecasts.
Long-term acid test - consumer confidence
Just as an artist steps back to take a look at the canvas from a different perspective, investors do well to take a look at the bigger picture.
This sounds very basic but is difficult in an environment of hype and enthusiasm. Heading into Wednesday, the S&P 500 has gone 30 consecutive sessions without losing more than 1%. More than 90% of all S&P 500 constituents are trading above their 50-day moving averages.
There is, however, a huge disconnect between the confidence shown on Wall Street and the confidence on Main Street, measured by the Conference Board Consumer Confidence Index.
One of the big stories last week was 6.1-point increase (from 46.4 to 52.5) in the Confidence Index. This increase is surely welcome but it misconstrues the true meaning of the index when taken out of context.
For most of the past decade, the confidence index hovered above 100. At the 2002 low, it briefly dropped below 60. In 2008, however, it dropped into the 20s and today it is still over 50% where it was a few years ago.
Wall Street may be on board with the rally and investors are enjoying their portfolio return to higher levels, but the American consumer - 75% of the US economy - is saying NO to an economic recovery or a new bull market.
Today, government transfer payments (GTP) represent about 20% of American's income. This represents a 12% increase despite a flat retail environment. GTPs are dead money as they do not create real output. GTPs include welfare, social security, unemployment and other subsidies.
The lack of growth in the consumer sector is seen in the bankruptcy statistics. There were nearly 160,000 bankruptcy filings in March, 35% more than in February and 19% more than at the same time last year. Why, again, are the major indexes rallying?
Long-term acid test - valuations
There's more than one way to make potato salad, but as long as you're using potatoes you'll still get potato salad.
There is more than one way to value the market, but as long as you are using current valuations - not future or projected values - you will find that the market is overvalued.
According to Yale Professor Robert Shiller, the long-term average price/earnings (P/E) average is around 16 xs. Prof. Shiller uses a cyclical adjusted P/E. With the S&P around 1,170, stocks have a P/E of 21. According to Shiller's analysis, stocks are 30% overvalued.
Using unadjusted P/E ratios published by Standard and Poor's,the P/E ratio based on actual earnings spiked above 100 briefly before settling at 84 at the end of 2009.
As the chart below shows, the historic pattern is that P/E ratios have to reach rock bottom to trigger a sustainable bull market, such as we've seen in the 1930s, 1950s, 1970s, and 1980s. The current P/E is far away from bull market territory.
Ultimately, equity investors pay for earnings. How can a company without profits generate profits for its investors?
Let's get real
Using deductive reasoning, you would assume that earnings today should be at around the same level as they were the last time the S&P was approaching 1,200, which was in 2004. In 2004, trailing fourth-quarter operating earnings (EPS) were $68. Today they are $57.
Much of the current earnings are caused by corporate savings due to layoffs, dollar depreciation, fiscal stimulus and financial engineering (such as an altered 157 Rule). How much of that $57 is real growth, very little? That means lower earnings and lower stock prices.
Another measure of growth is dividend yields. Years ago, dividend ETFs like the iShares DJ Dividend ETF, or SPDR Dividend ETF, and even value ETFs like the iShares Russell 1000 Value ETF came with a yield of 4% or more. Today it's below 2%.
Major market bottoms are identified by high dividend yields and low P/E ratios, not vice versa as we see today. Just as the human body is not healthy unless the body temperature clocks in around 98.6 degrees, the stock market is not healthy unless dividend yields and P/E ratios reset to fair valuations.
The ETF Profit Strategy Newsletter plots the historic performance of the stock market against P/E ratios, dividend yields and two other long term-indicators and discerns the target range for the ultimate market bottom. A picture paints a thousand words and those charts speak volumes about the market's future. Perhaps they are your acid test.
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