What Five Key Stock Market Signals Are Telling Us Now

In a volatile, uncertain time, investors are searching for guidance on what might come next. BW offers some places they might want to look

As U.S. stocks hit new 11-year lows on Nov. 20, many investors say they just don't know what's ahead.

There's a general lack of clarity on a wide range of issues—the state of the U.S. and global economies, problems in the credit markets, the plans of the federal government, and the fate of hedge funds that are being forced to sell off assets. Unfortunately, much of the fog of the financial crisis will not be cleared up anytime soon.

However, there are several key signals that traders, strategists, and fund managers typically watch closely in times of uncertainty. Given the unprecedented environment, it's not clear if any will be a reliable guide this time, but these signals do give investors something to monitor for clues to the road ahead.

Here's a review of five of those signals and what they're saying now:

1. Technical Signals

Technical strategists analyze and predict market activity based on previous market moves. This week, the stock market failed a key test: The broad Standard & Poor's 500-stock index not only fell below its October 2008 lows, but the big-cap benchmark also blasted below its lows during the nasty bear market of 2002.

On the morning of Nov. 20, the S&P 500 briefly tested these 2002 lows in the morning but then rebounded. But late in the day, stocks sank and the S&P 500 closed at 752.44. That's below the index's October 2002 low of 768.63 and the lowest level for the index since April 1997.

The 2002 lows are "a major support level," says Dave Rovelli, equity trader at Canaccord Adams.

Richard Sparks of Schaeffer's Investment Research says "you could see a cascade of selling" if stocks stay way below those prior lows. Before stocks fell to this level, people could "feel comfortable that that is a basement that the market might not go below."

2. Reports from Washington

Michael Yoshikami of YCMNET Advisors criticizes "a general lack of clarity from the Administration [and] federal agencies on what's happening and what the path out is."

On Nov. 20, Democratic congressional leaders said they would delay a vote on a bill to help the U.S. auto industry—efforts some Republicans have opposed—until December. U.S. Treasury Secretary Henry Paulson has raised eyebrows by changing the focus of the financial package a few times. Bush Administration officials are on their way out of office, but President-elect Barack Obama hasn't yet chosen his economic team, whose members would have no real power until Jan. 20 even if they were in place.

This flow of news from Washington is rattling investors, many market watchers say. "No one really has a good idea what the plan really is," says Bruce Bittles, chief investment strategist at R.W. Baird.

Chad Deakins, portfolio manager at RidgeWorth International Equity Fund (SCIIX), says he doesn't expect any clear signals from Washington until Obama takes office. "Until the new Administration comes to the White House and sets a tone and direction, it's hard to see strong upside in the equity markets," Deakins says.

3. Price-Earnings Ratios

By at least some measures, stocks are cheap.

The price-earnings ratio is a widely followed fundamental indicator of how cheap or expensive equities are. According to Thomson Reuters (TRI), analysts are predicting earnings for the S&P 500 of more than $80 per share in the next year. That's a price-earnings ratio of less than 10. For the last 10 years, the average trailing p-e ratio is 21.2, and the average for the past 20 years is 19.3. By this measure, stocks are at bargain levels.

And at least some buyers do see the cheap valuations as a huge opportunity. "This is a once-in-a-generation opportunity to buy the finest companies at prices that will look very low from the standpoint of future markets," says Marc Heilweil, president of Spectrum Advisory Services. Investors such as hedge funds are being forced to sell stock in "great companies," and he is taking advantage. "They're paying no attention to price."

But other investors—especially those with a short-term focus—warn that stocks might not be so cheap. The "e" part of the p-e is the problem. Analyst earnings estimates could be wildly wrong, especially if the recession in 2009 is nasty and deep. "Fundamentals are out the window," Rovelli says. "Nobody knows what earnings next year are going to be."

"Any p-e argument is vague at best," Sparks says. If a stock has a p-e of 15, it might be attractive, he says, but if earnings fall by half, that p-e will jump to an expensive 30.

4. Dividend Yields

Another fundamental measure for investors is the amount that companies pay to shareholders in dividends.

As stocks have fallen, the dividend yield on stocks has jumped. After Nov. 20's steep drop, the dividend yield on the S&P 500 index rose to about 4%.

A key comparison is with the yield on the 10-year Treasury note. For the last 51 years the dividend yield on stocks has been lower than the yield on 10-year Treasuries. But that has changed. With the 10-year's yield barely above 3%, equities actually pay more than safe government bonds.

But, as with p-e ratios, some investors are skeptical that this measure matters. Financial companies continue to cut dividends, and other firms could follow suit if the economy worsens.

5. The Federal Reserve

Over the past decades, investors have learned that falling interest rates eventually stimulate the economy and the stock market. So it's hard to ignore the Federal Reserve, which is expected to lower rates again when it meets in December.

Fed action, however, is another reliable market signal that has lost its resonance with many investors. Bittles says "the problem [with the credit crisis and economy] is not the level of rates." Low interest rates by themselves won't stimulate lending by banks, he says. The problem is "trying to find customers with healthy enough balance sheets to lend to."

Amid so many confusing signals, many traders and investors are sitting on the sidelines, waiting out the market volatility. "All the smart people are just going to wait until the new year and see how this plays out," Rovelli says.

That's not surprising given the environment. A careful reading of the traditional signposts—Washington policy, fundamentals, the Fed, or technical indicators—suggests that the market has moved into uncharted territory.