“In the poison’d entrails throw.—
Toad, that under cold stone,
Days and nights has thirty-one;
Swelter’d venom sleeping got,
Boil thou first i’ the charmed pot!”
– Macbeth, William Shakespeare, 1606
While a bubble of epic proportions is taking place in cryptocurrencies today, signs of a bubble are notably absent from another notable and arguably far more important segment of capital markets. But just because a bubble is not immediately present does not mean that conditions are not ripe for some sort of asset price escalation to soon take shape in relatively quick order. Prepare to float higher any future asset bubble, but also keep your feet on the ground in knowing exactly the market that you are investing in today.
A primary concern among many investors in today’s capital markets is the following – are we in yet another major stock market bubble? When considering the SP 500 Index (SPY), which is the primary benchmark to measure U.S. stock market performance, the answer is definitively NO.
Now before going any further, some important points must be clarified. The U.S. stock market is expensive today. In fact, it is about as expensive as it has ever been. And this is true even if you adjust it for the historically low interest rates that global capital markets continue to enjoy today.
But just because stocks are expensive today does not mean that they are in a bubble. A true asset bubble is accompanied by a variety of other factors such as a profound sense of euphoria. And one need not search very far to find scores of investment analysts including yours truly that maintain a decidedly bearish view about today’s stock market and how things are set to play out over the long term. Put simply, today’s stock bull market has not risen because of love. Instead, it has risen despite the scorn and loathing of so many investors over the past nine years. It is known as “the most hated bull market in history” for good reason.
And even if you detest the ongoing rise of today’s stock market and think this is all going to end badly in the long term, this does not mean that you should not actively participate in its rise in the meantime. For if it remains determined to go higher, investors might as well participate in the short term to intermediate-term upside as long as it remains on offer. This is particularly true if stocks have yet to enter the bubble that so many investors think the market is already in.
So regardless of whether you are an unabashed bull or an unwavering bear, it is worthwhile to assess where we are from an asset price inflation standpoint when it comes to stocks.
The U.S. stock market is not in a bubble today as mentioned above. To emphasize this point, it is worthwhile to compare today’s stock market to recent stock price bubbles including the NASDAQ (QQQ) in 2000 and China (FXI) in 2015. Stock market bubbles have a clearly discernible size and shape as demonstrated in the chart below. And today’s SP 500 Index (IVV) does not share the characteristics that defined these two most recent bubbles. In particular, nowhere do we see the “elbow” in prices where stocks enter a new higher overdrive gear in skyrocketing to the upside. In short, the euphoria that typically comes with stock bubbles is clearly still missing in today’s stock market.
This should serve as an important point of reassurance for stock investors. For if stocks are not demonstrating bubble-like characteristics, then they are less likely to be subject to the sudden sharp and dramatic declines that come once the bubble has finally burst.
Of course, just because stocks (VOO) are not in a bubble does not mean that they are completely impervious to a major market decline. One has to look no further than the bull market in stocks from 2003 to 2007 and what followed from 2007 to 2009 to see that stocks can still suffer through dramatic and staggering bear markets even without the presence of a stock price bubble.
But an important distinction came with the bull market in stocks (DIA) in the mid-2000s. While stock prices themselves were fairly reasonably priced, their rise was accompanied by a major housing bubble that nearly felled the global financial system before it was all said and done.
This leads to an important point. If the financial system itself including the banks comes under stress from the bursting of a separate bubble in another entirely different market segment, it may be enough to bring the market down with it.
But once again, a point of reassurance for investors today is that the U.S. banking system is about as strong and well-capitalized as it has been in a long time. And while the same might not be able to be said about the banking systems in other parts of the developed and emerging world, we have global central banks that are committed both by word and action to do “whatever it takes” to avoid a financial system meltdown.
Even if stocks can survive the bursting of bubbles in the likes of Bitcoin does not mean that they also cannot be completely taken out by outside shock factors. One has to look no further than the early 1970s when investors were all hopped up on the “growth at any price” notion of the Nifty Fifty stocks. Valuation be damned, investors proclaimed at the time, for these were blue-chip growth stocks that will continue to grow regardless of the economy and can be bought and held forever as a result. Does any of this sound familiar to the narrative surrounding the likes of Apple (AAPL), Facebook (FB), Google (GOOGL) (GOOG), Amazon.com (AMZN), and Netflix (NFLX) among many others today? And does any of this sound familiar to the thinking surrounding passive index investing in general today? History has an uncanny way of repeating over and over again, doesn’t it?
So even with the lack of any measurable signs of a stock bubble, we still saw the SP 500 Index plunge by more than half on a real basis, thanks to sharply rising inflation including the onset of the oil crisis.
Yet again, investors today continue to find reassurance in the fact that inflationary pressures remain stubbornly benign. And even if they do ignite, many embrace the notion that such rising inflationary pressures will be accompanied by commensurate economic growth that will undoubtedly sink bond prices while simultaneously lifting stock prices. I, for one, do not subscribe to such a rosy scenario, but this will make for the basis of good debate once inflationary pressures finally return to capital markets.
In the meantime, investors should also be prepared for the following fact. Nifty Fifty investors in the early 1970s did not see the inflation and oil crisis freight train coming. If they did, they would have started working to make more fuel-efficient cars prior to the onset of the crisis, not starting a few years after the fact. So while investors can find reassurance that no signs of shock trouble loom on the horizon today, more often it is the shocks that nobody sees that result in the most trouble. That’s, after all, why they are known as “shocks” and not “saw it coming a mile aways.”
But beyond these downside risk factors (among others), it remains that today’s stock market as measured by the SP 500 Index is not in a bubble.
But with this in mind, it is important for investors to consider the following. Just because we are not in a bubble today does not mean that we might not find ourselves in a stock market bubble at some point in the not too distant future.
I have been writing for some time now on Seeking Alpha about the potential for the stock market to enter into a bubblish phase. The following are a few examples over the past several months.
But wait a second, Parnell! Aren’t you a stock market bear? How can you be predicting that the stock market could go up – a lot for that matter – if you are bearish? Because I’m bearish in that I think everything that has taken place from a global policy perspective since about 2010 is going to end badly someday. Not tomorrow, not next week, maybe not even next year, but someday. In the meantime, markets could rise to the moon before they fall through the floor, and investors should be prepared for what lies ahead while at the same time participating in what the market has to offer today. Risk cuts both ways – to the upside and downside – and extends over multiple time periods. And if stocks are going to go up for whatever reason in the short term to intermediate term, investors should be positioned to participate in it in a meaningful way and for as long as possible.
One additional point to mention. Bubbles are not bullish. Bubbles are bearish.
And when it comes to today’s stock market, the pre-conditions are increasingly coming together to send today’s stock market on a bubblicious moon shot before it’s all said and done. Not saying it will happen. But the probability is rising that it could happen.
How could such a rally be possible with stocks already trading at a historically high multiple at over 25 times trailing 12-month GAAP earnings so far into the second-longest bull market in history at nearly nine years and counting?
First, it is worth noting that we were eight years into the longest bull market in history back in 1995 when the tech bubble started to find its giddy up.
Second, in the eighteen months stretch before stocks reached their final peak, stocks were trading at an even frothier 32.6 times trailing 12-month GAAP earnings in 1998 Q4. In fact, earnings multiples actually contracted back to 26.8 times earnings during the final market run-up to its final 2000 peak, thanks to a +40% increase in corporate earnings over this same time period. In short, everything looked like it was firing on all cylinders for the economy and the stock market. That is, of course, until it suddenly wasn’t.
Third, U.S. fiscal policymakers through the recent tax cut legislation just injected a heavy shot of juice into an economy that is already at the late stages of an economic cycle and is operating at full employment in many respects. If nothing else, this fiscal stimulus is likely to jack up corporate earnings for the next few quarters, thanks to the cut in corporate tax rates among other factors. Such may be the fuel to drive a similar +40% increase in corporate earnings into 2019 similar to what we saw at the turn of the millennium.
Lastly and perhaps most importantly, global monetary policymakers remain troublingly complacent and worryingly slow in withdrawing the unprecedented amount of stimulus that they have poured into the worldwide financial system for so many years. When the financial crisis was at its height, the major global central banks had a collective total of less than 6.5 trillion on their balance sheets. Today, they have over 20 trillion, which is a more than threefold increase. Yet despite all of the excitement about a coordinated global economic recovery, three of the four major global central banks in the European Central Bank, the Bank of Japan and the People’s Bank of China are still expanding their balance sheets at a healthy pace (the PBOC took a few years off, but lately they’ve been back at it).
As for the Fed, while they have moved to raise interest rates over the past couple of years, they remain notably if not frustratingly cautious with no shortage of Fed officials willing to step before a microphone and say as much no matter how lofty asset prices might be trading at any given point in time. And despite having sparked the creation and managed the clean-up of two major financial bubbles over the past two decades, both of which occurred with benign inflationary pressures that helped justify the easy monetary policy at the root of both events, the Fed remains largely focused on inflation yet again while largely dismissive of the potential that they may be, as we have been repeatedly speaking for the past six years or so now, committing the same exact financial bubble mistake for a third time around.
At what point do the frustratingly elusive global economic recovery and latent inflationary pressures for so many years suddenly transform into a global economic boom that is spiraling out of control and sending asset prices of all shapes and sizes skyward in the process. Even something falling somewhat in between may be enough to send the U.S. stock market flying to the upside in historically notable fashion.
So what might any future stock market bubble look like? A helpful guide might come from the gold (GLD) market, of all places. Why gold (IAU)? Because when markets enter into bubble territory, fundamentals tend to matter less and momentum matters more. Put more simply, once you enter into a more euphoric space with financial assets, they all tend to behave the same way. It becomes less about the assets that make up the bubble as it is about the defining characteristics of the bubble itself.
Now before going any further, it is important to make clear the following caveat. I am not saying the following will happen. Instead, I am considering the possibility that something along the lines of the following could happen. Same goes with the various downside risk scenarios that I am considering at any given point in time. Such is part of the exercise of prudent risk management, for it is just as prudent to protect against the risk of loss associated with holding an asset that is declining as it is to protect against the risk associated with the opportunity cost of not holding an asset that is rising.
With this in mind, let’s look back on the period from April 2001 to August 2011. This was an extraordinary ten-year-plus period for the gold market that brought with it a more than +600% increase from trough to peak in the yellow metal.
Why is this comparison relevant to stocks today? Two reasons.
First, stocks have followed a notably similar path to gold over the first nearly nine years of its own bull market run. In short, the characteristics are the same to date (yes, correlation is not causation, but remember that when it comes to asset bubbles, particularly when they enter their later stages, it becomes less about the cause and more about the correlation).
Second and perhaps more importantly, despite the extraordinary run that gold (PHYS) entered into in its final eighteen months before reaching its final peak – a point that stocks could very well be starting from today with the jet fuel of the recent tax legislation now starting to flow its way into the markets – it was reasonably argued all along the way that gold was not trading at excess premiums but instead was still reasonably valued, based on underlying economic fundamentals and relative valuations. Sure, gold was running hot, but not excessively so despite its impressive price appreciation to that point.
Such is the setup for stocks today. They have the policy fuel already in place to run to the upside. And even if they doubled from here to 5600 on the SP 500 Index to match the move of gold in the last 18 months of its decade-long bull run, stocks would still only be trading at 36.5 times estimated 2019 GAAP earnings if companies were actually able to hit their profit targets between now and then, which is still a big lift but more likely than usual thanks once again to the recent tax legislation and still ultra-accommodative monetary policy that promises to have abundant liquidity still sloshing around by the time global central bankers have finally shut off the monetary spigots and have started opening the monetary drains for the first time during the post crisis period by the end of 2018 and into early 2019.
Of course, it should be noted that gold eventually gave this final doubling back with a -45% peak to trough decline over the next four years after its August 2011 peak before finally bottoming in December 2015. The subsequent bounce in the two years since? Solid, but not spectacular, and still trading nowhere close to its August 2011 highs through today nearly six years later. And this has taken place in a global environment where global liquidity is gushingly abundant. Imagine an environment where liquidity was constrained instead for one reason or another. Whether you are a big hunk of gold or the greatest publicly traded stock in the world, without sufficiently abundant liquidity in the global financial system, your asset price is simply going nowhere good.
“Double, double toil and trouble, fire burn and cauldron bubble”
– Macbeth, William Shakespeare, 1606
I had the opportunity to play the lead role of Macbeth in my fifth-grade play. Unfortunately, I don’t remember any of the lines from my brief thespian turn so long ago. But the one line that sticks with me to this day is that of the three witches quoted above. And perhaps it has for good reason.
Certainly, a doubling of the stock market in bubble-like fashion would be an intoxicating prospect. After all, I have witnessed no lack of swagger among the cryptocurrency crowd as of late. And if the stock market is indeed set to double over the coming year or two, so stock investors with the appropriate risk tolerance should remain on board to fully participate. But know all along the ride that an increasingly meaningful cost comes along with a stock market or any asset for that matter that has already been deliberately inflated by policymakers for so many years, being propelled even further to the upside by these same policymakers. Doubling stocks in the short term has the very strong potential of yielding twice more the toil and trouble for investors once the euphoria finally stops.
Today’s stock market is not in a bubble. But the potential for a bubble is becoming increasingly real. Enjoy the ride to the upside for as far and as long as you can reasonably tolerate, but know all along exactly what you are investing in and who you are investing alongside with. For stock market fundamentals were already disconnected long ago (and that includes the anticipated increase in earnings over the coming quarters – this was priced into the stock market years ago now) and those that have been driving the market higher have not been the everyday investor (it has been due almost exclusively to corporate buybacks supported by historically low interest rates that have more than offset more than -$1 trillion in net outflows out of domestic equities by retail and institutional investors since the end of the financial crisis). For as long as you know the market in which you are investing, the less likely you will get caught up in the excitement and eventual trouble of it once the inevitable fall back to earth finally comes to pass.
Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.
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Disclosure: I am/we are long RSP,SPLV,PHYS.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.