I published a post a few days ago on the issue of whether stock markets were in a secondary (i.e. cyclical bull) or primary bull market.

I quoted a research project by Ned Davis (Ned Davis Research) in which he identified seven dimensions one could use to compare the March 9 low with secular lows of the past. The research showed that only one of the seven criteria indicated a secular bull was in place, whereas three were neutral and three were bearish. Although Davis believed the nascent rally had more upside potential, he concluded, like Richard Russell, that we were dealing with an extended rally (cyclical bull phase) within a secular bear market.

Davis has now turned his focus to what criteria would signal that one should exit the rally. His yardsticks were reported by Mark Hulbert on MarketWatch and are as follows:

(1) Valuation. Davis would look to exit from stocks whenever the P/E ratio on the S&P 500's normalized earnings reaches 20. Putting this indicator into practice is a bit tricky, since it requires normalizing those earnings - adjusting them, in other words, for where we are in the economic cycle. Nevertheless, Davis calculates that normalized earnings on the S&P 500 Index/quotes/comstock/21z!i1:inx currently stand at around $60″, which suggests Davis will be looking to start exiting the market at the 1,200 level.

(2) Sentiment. Davis maintains his own sentiment index, which he calls his Crowd Sentiment Poll. This index currently stands at 62% according to Davis, which is just above the 61.5% level he considers to be the lower bound of extreme optimism. He says that on past occasions when this index rose above 61.5%, its eventual peak has averaged 68%. He says reaching that level this time around would be a sign for traders to begin selling weak performers.

(3) Internal market divergences. The indicator that Davis relies on here is one created three decades ago by Norman Fosback, who currently edits a newsletter called Fosback's Fund Forecaster. The indicator is called the High Low Logic Index, which represents the lesser of new 52-week highs or new 52-week lows as a percentage of all issues traded. Fortunately for the current market, this index is solidly in bullish territory right now at 0.8%, according to Davis' calculations. He says it would have to rise to around 2.5% before he would start looking for the exit signs.

(4) Rising interest rates. Davis has found from his research that one of the best market-timing indicators in recent years has been the 26-week rate of change for investment-grade bond yields. With that rate of change currently standing at minus 12.6%, a sell signal from this indicator is not imminent.

Davis concludes that only one of these four indicators is even close to flashing a sell signal and he therefore gives the bull the benefit of the doubt (but in a secular bear market).

I find it difficult to pinpoint a top in a momentum-type market as we are experiencing now, but am concerned about the fact that the S&P 500 is now priced for 40% earnings growth and 4.0% real GDP in the coming year (as calculated by David Rosenberg of Gluskin Sheff & Associates). Looking at the next few weeks, I see no reason to alter my assessment as stated a few days ago: I am of the opinion that stock markets have run away from fundamental reality and that a pullback/consolidation looks likely. Taking a slightly longer-term view, I think we are in a (possibly lengthy) bottoming-out phase as far as slow-growth (OECD) countries are concerned, but already in new (potentially volatile) uptrends regarding high-growth emerging and commodities-related markets.

In the short term, caution seems to be in order.