In our August 25 Commentary, Looking Into Our Crystal Ball, we presented a few assets that have gone parabolic in recent history, along with the aftermath of the parabolic price movement. Among the assets we cited were Japanese equities (1982-1990), U.S. Tech stocks (1992-2000), U.S. Housing (2002-2006), and Chinese equities/real estate (2006-2007). Of course there are many more examples of parabolic price action over the last 30 years (uranium in 2007, property bubble in several countries around 2000, silver 1979-80, etc). In 100% of the cases, the net final result was a painful bust as investors fled from the assets after prices lost touch with reality. Given the certain probability of a negative outcome, it is indeed a curiosity to see U.S. equity indexes in a parabolic price rise with investors pouring money into stocks, effectively ignoring the lessons of history.
We are neither making a gloom and doom warning nor sending a euphoric message to jump into equities today. The purpose of this article is to reaffirm our opinion that U.S. equity indexes are likely in an advanced stage of a bubble. If an investor plays his/her cards right, there is lots of money to be made in a bubble. But the operative word is plays, as speculation is rampant in this market and those who do not react precociously to a future turn in prices will be forced to react tardily, at no small cost to your portfolio.
Of course we can not be certain, in advance, that U.S. equities are in a bubble (bubbles are only know after the fact). The reasons prices rise sharply is that the majority believe in a new paradigm, a new permanent level of prosperity in the asset. Who does not believe today that Apple, Microsoft, Facebook, Google, and Amazon are the five greatest companies of all-time and their businesses will improve the lives of each and every citizen on planet Earth?
Our argument in favour of the bubble scenario is based firstly on the nature of the equity rally, driven to a large part by central bank endless liquidity. Some financial writers are calling the U.S. equity rally an earnings driven bull market. Our rebuke of this line of thinking is that earnings are, for the most part, being manufactured thanks to artificially low interest rates. In theory (and by recent empirical experience), as long are borrowing rates remain below the equilibrium level of rates that should prevail in the 8th year of an expansion, companies can continue to produce earnings and the equity price bubble will grow even greater. We would also note that each earnings season, company earnings announcements generally beat consensus forecasts, but these forecasts have been systematically revised down over the quarter. Is jumping over a lowered hurdle a reason to rejoice? At the moment, equity markets are saying yes.
Given the backdrop of a central bank engineered economic expansion, we share below several market-based indicators that have reached levels that historically have coincided with market tops. These include the absence of short sellers in the market and the extreme level of margin debt.
To begin, lets step back and look at the major U.S. indexes to appreciate the parabolic moves in progress.
Dow Jones Industrial Average:
Borrowing money against ones portfolio to double down on bullish bets has been a very profitable strategy. There are two problems with this today: (1) everyone is doing it, and rarely does everyone make money doing the same trade, and (2) leverage works in both directions when prices start falling, forced position closures will multiply quickly.
The chart below shows NYSE margin debt relative to GDP through September. We can safely assume that the margin debt figure for October will be even higher. If you are reading this article, we dont need to explain this chart.
Typically, some people anticipate higher prices (bulls) while others anticipate lower prices (bears) this is what makes a market. Today, however, equity index investing is a one-way street. By definition this is not normal.
When there are so few shorts in a market, the risk of a market drop should be relatively high. Of course with central banks suppressing volatility, the one-way street is (and may continue to) lasting much longer than historical precedent. We firmly believe, however, that the absence of short-sellers represents a systemic risk for equity markets.
We first wrote of the Big 5 back in our May 5 Commentary (The S&P 500 or the S&P 495). Everyone knows that Apple, Google, Facebook, Amazon, and Microsoft are driving the index performance. Even within the Nasdaq index, performance is diverging from the Big 5 and the rest of the index components. Last week, the Nasdaq broke out to another record high (red line below). However the number of issues advancing verses those declining, the Advance/Decline Line (in blue), has been trending down for a couple weeks. It is generally not healthy when prices make new highs while the A/D line does not confirm by matching the new price highs.
200-Day Moving Average
In the same vein, when fewer and fewer index components are trading above their 200-day moving average, we say that market breadth is poor. Again, a healthy market really should see an increasing number of issues above their 200-day moving average. As shown below, despite record index highs last week, only 71.5% of S&P 500 stocks closed above their 200-day moving averages, compared to over 84% back in March.
Taking the same Percent above 200-Day Moving Average for the whole NYSE, we created the chart below. Divergences between NYSE Composite Index price and the percent above moving average tend to get resolved by a correction in the index price.
We have cited previously the Shiller Price-Earnings Ratio, which adjusts earnings using the average inflation rate over the past 10-years. As the October 27, 2017 its official, the current S&P 500 Shiller valuation at 31.49x is above the peak on Black Tuesday in 1929.
We compared the Shiller PE with the current PE based on 12-month forward earnings. Valuations at 19.5x (21.5x trailing earnings) are now above the prior bull market peak and well above the median PE since 1990 at 15.9x. Stocks are not cheap, but as we saw in the late 1990s, in bubble territory forward PE has climbed to 27x. Again, as suggested in the title of this Commentary, will market participants let this happen again and bid up stocks knowing that the reversal down will wipe out all gains? Given that machine trading programmes are driving prices higher, anything is possible.
One final consideration. We believe that rising bond yields pose the greatest risk to equity markets going forward. As money becomes more expensive, companies will be less generous with dividend payouts and share repurchases (never mind the higher interest cost for company operations). This week brings a host of market moving news for bonds, at a critical juncture from a technical perspective: announcement of a new Fed chair, release of a draft of the tax bill, along with key inflation and jobs numbers.
If the U.S. 10-year yield starts closing above 2.5% (breaking above the red trend line below), we could see bond traders begin pushing yields higher. While some (Jeffrey Gundlach and Bill Gross, notably) are looking for the end of the bond bull market, we can at least agree that higher yields will make all risk assets less attractive.
In early 2009, investors dumped U.S. equities regardless of the prices. People just wanted out. Today we are essentially experiencing the flipside of early 2009. Investors are pouring money into equities regardless of price. Between the chase for yield and the pressure on investment managers to avoid underperforming, macroeconomic risks and fundamentals are being forgotten. We dont know when, nor for what reason, equity markets will reverse down, but we have a high degree of certainty that financial markets have not achieved a new paradigm of permanent prosperity for equity investors. As usual, recent investors wont sell until their gains turns to losses and investor psychology kicks in: the pain of losses is much greater than the satisfaction of seeing gains. Until the uptrend is broken, however, the risk remains to the upside as markets melt-up. Bull or bear, investors need to recognize that investing today entails outsized risk and that a buy/hold or short/hold strategy are both recipes for disaster.