Another day, another gain. That’s been the story for the S&P 500 lately, which has rallied higher in 12 of the last 15 trading sessions since January 20. As they say, “this bull has legs.” A rising market is surely enjoyable, but the higher it moves, the greater the chance that profit-taking will be just around the corner. That may happen when market strategists begin to talk about stocks becoming expensive when measured by traditional metrics. So here are four items I watch to see if the bull can keep running…

1. Money pouring into domestic stock funds — POSITIVE
The direction of the stock market is simply a function of supply and demand. When fund managers are given more money to work with, they put it into stocks, pushing share prices up. And they got plenty of firepower last quarter, bringing $45.5 billion, according to Lipper Fund Services. (90% of that went to actively-managed funds and the rest went to exchange-traded funds, or ETFs.) That was more than funds took in for the first three quarters of 2010.

And the spigot keeps flowing. In the past two weeks (ended Feb. 2), they’ve taken in about $6.7 billion, which works out to be roughly $40 billion on a quarterly basis. Curiously, the last two weeks have seen a major shift away from actively-managed funds and toward ETFs, though I’m not sure what that that means. Net/net, as long as money is pouring into the market at the current rate, then stocks have the fuel to keep rising higher.

2. Individual investor sentiment — MILDLY NEGATIVE
Many individual investors are quite savvy. But as a herd, they’re not as clever. They tend to become bullish and bearish at precisely the wrong times, as I noted in this article.

Investors were very bearish last August, just before the market staged an impressive rally. That’s no longer the case. More than 50% of investors have been bullish in eight of the last nine weeks, according to recent surveys by the American Association of Individual Investors (AAII).

The last time that reading was above 50% for a sustained two-month stretch: November, 2004. The S&P 500 has risen 14% since then — over a period of more than six years! If you really wanted to get excited about stocks, you’d prefer to see most investors acting bearishly. That said, readings closer to 60% bullishness would be really scary, and we’re not quite there yet.

3. New Highs and Lows –POSITIVE
As noted over on our sister site, investinganswers.com, it’s a bullish sign when the number of new highs is rising along with the market. In the past two weeks, this measure has wobbled a bit, but it has already surpassed 300 on two occasions in February. You’d have to go back to 2007 to see such bullish action. Equally impressive, new lows have been stable in the 10-20 range each day in that period.

 
4. Robert Shiller’s CAPE — CLEARLY NEGATIVE
Up until now, we’ve looked at peripheral issues such as money flows, investor sentiment and technical indicators. But how do stocks really look compared to the past? By one measure, they’re getting expensive. Robert Shiller, who is well-known for a home-pricing index he pioneered with Standard & Poor’s, has also been consistently analyzing the market’s price-to-earnings (P/E) ratio — but with a twist. He adjusts the market’s P/E to account for inflation‘s impact on earnings in the prior 10 years, which he calls CAPE (Cyclically Adjusted Price-to-Earnings ratio).

According to Shiller’s research, that measure now approaches 24. Two years into prior bull markets, that figure typically stood at 18, so we’re overvalued by more than 30% — relative to earnings and past economic cycles. That doesn’t mean that stocks are primed for an imminent fall. Indeed, the major indexes can stretch well past normal ranges for an extended period, as we saw in the 1990s. But it does mean that future gains may be very limited as earnings “catch up” to the market.

Equally sobering, sales and profit growth looks set to cool in 2011 after a solid snapback in 2010. After rising about 45% in 2010, profits for the S&P 500 are expected to rise 12% in 2011 and 9% in 2012. Above-average multiples and a slowing earnings growth rate are not the recipe for continued market strength.

Action to Take –> I continue to believe that this bull market will soon tire out, despite the reasonably bullish indicators cited earlier in this article. The market continues to make new highs, which tends to become a self-fulfilling prophecy as bad news is ignored. But what happens when the market starts to move sideways and ceases to make new highs? At that time, I suspect, the market’s seemingly rich valuation will start to dominate the industry chatter. And a flattening out of the rally may bring back the short-sellers, many of whom have been cowered into submission by this ever-rising market.

What I wrote a few weeks ago still stands: “After a furious 22-month run, it’s time to be more cautious. If you’ve had any massive winners that now sport price-to-earnings (P/E) ratios well above where they were a year or two ago, then you should think about harvesting profits.”