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Don’t Ignore These Market Warning Signals

You might not suspect it at first glance, but sometimes NASCAR racing has parallels with investing. I’m a causal fan of NASCAR racing — I will watch the big races like Daytona 500 or the Bristol night race if nothing else is going on at the time. I’ll even go to a race or two if someone offers me free tickets during the season.

warning-signals-rell-aoslOne thing I have learned as a fan that is that when the caution comes out, it’s time to go to the kitchen or concession stand and get a snack. Nothing is going to happen until they get the mess on the track cleaned up, and that’s going to take a while. The stock market works pretty much the same way.

Let me make clear that I do not make specific predictions about the market direction. I have never made a correct, time-specific call about the market. When I was a lot younger, I used to bet on what I thought were brilliant conclusions about the near-term direction of the stock market … and each time led to magnificent and immediate losses.

I have, however, learned that when the caution lights are out it’s a good time to step away and not try to force things in the market, regardless of which way it ends up moving. It’s a good time to make sure everything I own is safe and cheap, and it’s a great time to raise cash by shedding stocks that are approaching my fair value estimates.

There a few conditions and measures I have found to be very effective warning signals over the years, and some of them are flashing right now.

Warning Signal #1 — Shortage of Cheap Stocks

The first, and brightest, yellow light comes from the number of safe and cheap stocks out there. Right now there are very few stocks that pass my safe and cheap screens. The flow of free money has stretched valuations, and I can only find enough qualifying stock to be about 35% invested in a new money portfolio. That’s a major warning signal.

The closest thing to a cheap, safe stock right now is Richardson Electronics (RELL) which trades at 120% of net current assets. There a few stocks like Pan American Silver (PAAS) and Alpha & Omega Semiconductor (AOSL) that are too cheap not to own, but the list of such stocks is as small as it was back in late 2006.

Warning Signal #2 — Median Appreciation Potential

Another very reliable warning signal is the Value Line Median Appreciation Potential reading. Every week, they publish an estimate of the projected appreciation of stocks in their universe, and it has consistently proven predictive.

Professor Daniel Seiver of Cal-Poly found that when the median appreciation potential of the Value Line universe was more than 100%, it was time to buy stocks. When that number dips below 55%, it is time to start raising cash. Right now, the number is sitting well below that benchmark, at just 30%.

Warning Signal #3 — Market-Cap-to-GDP Ratio

The market-cap-to-GDP ratio is also at levels higher than it was in 2006, right before everything unraveled. This measures the total market capitalization of U.S. stock against U.S. GDP.

Warren Buffett once called this measure “probably the best single measure of where valuations stand at any given moment.” When the market cap exceeds the GDP, owning stock becomes riskier. Right now the measure stands at 116%, which is also higher than the 2006 and 2007 market peaks.

It is so easy to get caught up in the short-term day-to-day. The siren song of the market casino calls to us to try and guess Apple’s (AAPL) fourth quarter earnings or speculate on the likelihood of a Sears (SHLD) turnaround. But if we step back, it becomes easier to see that the caution lights are lit, and it might be a great time to slow down and quit chasing stocks.

As in NASCAR, slowing down when there are dangerous conditions by holding some cash in a heated market is a great, safe way to protect your investments.

As of this writing, Tim Melvin was long PAAS, RELL and AOSL.

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