Skip to main content

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

By Andrew McCormick

NEW YORK (

TheStreet

) -- Holding stocks at the top of a secular bear market rally is the single most dangerous position an investor can find. Unfortunately, that's exactly the situation investors could face shortly.

U.S. equities have doubled in price from the 2009 lows and now show convincing deterioration fundamentally, cyclically and from a contrarian standpoint. The stock market remains in a secular bear market that began in 2000, but most wouldn't know it after the current two-year rally.

Although many see the U.S. in a recovery and corporate earnings on the rebound, the reality remains that the U.S. stock market supports itself with a crutch of government bailouts, a dangerous need for speculation resulting from an investment landscape devoid of yield, two rounds of quantitative easing and the threat of QE3 this summer.

Fundamentally Overvalued

Investors face an investment environment where, starved for yield, they have been forced to speculate in stocks. This need for investors to speculate has forced the

S&P 500

to historically overvalued levels. Two common methods for valuing the stock market are the P/E ratio (stock price divided by earnings per share) and the Q ratio (company's market value divided by value of the company's assets). Both measures indicate that U.S. stocks are dangerously overvalued, to a historical degree.

Using current earnings, the P/E ratio of the S&P 500 stands in the top 10 percent of all historical valuations. Lastly, aside from only to the final years of the tech bubble, the S&P 500's Q Ratio shows current valuations to be higher than every single historic period dating back to 1900.

Poor stock market performance always follows historically high P/E ratios. The data shows the average 10-year inflation adjusted return following a top-10% valuation period as an entry point is less than -8%. At this point in time, stock market investors should certainly expect sub-zero percent returns over the next decade.

During market tops, steep valuations come with the terrain. The year 1999 saw extreme valuations as technology start-ups with negative income garnered billion dollar valuations. Today, Facebook.com is valued at more than $55 billion. That price tag is almost three times what you could pay for Dell Computers, which manufactures a product that will let you access the entire Internet, not just one Website. Facebook.com is now incorrectly valued similarly to major corporations like

Boeing

(BA) - Get Boeing Company Report

,

Visa

(V) - Get Visa Inc. Class A Report

,

Altria

TheStreet Recommends

(MO) - Get Altria Group Inc Report

and

Union Pacific

(UNP) - Get Union Pacific Corporation Report

.

Cyclically Overvalued

The U.S. stock market remains in a secular bear market, which is understandable. Investors enjoyed an unprecedented 20-year secular bull market that ended with fireworks in 2000. The S&P 500 appreciated by almost 15 times throughout that period, generating a massive amount of wealth across developed economies. Markets have historically consolidated and adjusted for approximately 20 years after a secular bull market ends.

Many investors think or hope that this time will be different, but there are absolutely no reasons to believe that markets will be spared a decline to levels of genuine value. The average duration from an inflation adjusted price high to the ultimate low during secular bear markets is approximately 17.5 years; the current bear market has only existed for a little over 11 years. Meaning, markets could have an additional 6.5 years of depressed prices remaining.

The average decline during a secular bear for the

Dow Jones Average

is approximately 44.5%. When stock prices finally roll over, a 44.5% decline will place the market averages back down near the lows of the 2008 financial crisis. Conceptually, a secular bear market must produce enough pain for investors that they throw in the towel and give up. Only when this bear market forces enough investors to change their previous investment habits will the foundation be completed for the next secular bull market to begin.

Historically, bear market rallies in the Dow Jones Average and Japan's Nikkei last an average of 26 months. The current rally in U.S. stocks has lasted 25 months. Those who think equities are in the clear after a two-year rally simply have not studied the data.

Even though markets are close to their average bear-market-rally duration, this does not mean a decline is necessarily imminent. But this historical observation does put conditions in perspective. Investors during past secular bear market rallies often thought conditions had improved and a new bull market had begun. They, too, extrapolated current trends to convince themselves that the market was, indeed, cheap as they looked into the future.

Contrarian Catalyst

Individual investors, as a whole, are always wrong at major market turns. They remain heavily invested at market tops and shun equities at major lows. Data from the

Federal Reserve

shows investors have returned to stocks in numbers not seen since late 2007. As in previous bear market rallies, the higher the stock market rises the more general investors have allocated to equities.

The last piece needed to convincingly make a top in the U.S. stock market has materialized -- the contrarian component. Stocks are popular again. This is the same cycle of investor psychology that has repeated itself throughout the history of the stock market.

As a whole, mutual fund managers are also historically wrong at major market turning points. They face client pressure to be heavily invested and to take full advantage of upward market moves, forcing full investment at market tops. When they have fully invested, who remains to buy?

Tracking mutual fund cash levels helps determine how mutual fund managers are allocated and can assist in identifying market tops. Historically, when the average cash level drops below 4.5%, a substantial market top often occurs within the following twelve months. Mutual fund cash levels hit an all-time low in July 2010 at 3.4%.

A top in equities may not occur overnight; market tops can take months to develop. Therefore, stock prices could advance or churn for several more months. After that time, the greatest direction of vulnerability will be downward. Every piece of the investment puzzle has been assembled; fundamental, cyclical and contrarian data collectively point in harmony to dramatically lower stock prices in the future. The synergy could be dramatic.

Andrew McCormick is the managing member of MKC Global Investments, LLC and the portfolio manager for the MKC Global Fund, LP. The fund services high-net-worth-individuals and invests in global commodity, currency and financial futures. Mr. McCormick lives in Seattle and contributes periodical material to ZeroHedge.com, a financial Website.