Bubble Watching
As we have noted here before, we believe that financial markets have generated the biggest bubble in history. There are many supporting facts for this view, from extreme measures of market sentiment to prolonged record low volatility, unprecedented low interest rates, record levels of leverage and historic over-valuation.
Bubble Watching
As we have noted here before, we believe that financial markets have generated the biggest bubble in history. There are many supporting facts for this view, from extreme measures of market sentiment to prolonged record low volatility, unprecedented low interest rates, record levels of leverage and historic over-valuation.
The bulls will try to tell you that earnings, economic growth and low interest rates justify record stock market performance. But a little thought brings these assumptions into question.
S&P500 earnings have only recently managed to climb above the 2014 high water mark but the index has jumped 40% higher; the run in stocks is due to P/E expansion, not earnings growth.
The economic recovery since 2008 has been the weakest on record, with shockingly poor performance in key parameters such as productivity, wages and capital investment.
Interest rates have gone to 5,000 year lows which have made dividend-paying stocks look attractive but the same factor cannot continue to drive stocks higher, especially as interest rates have now begun to rise.
Earlier this week, we had the first real warning that the financial asset bubble is beginning to burst...an 1178 point one day drop in the Dow Jones Industrial Index. Yesterday, we had another 1000 point drop. Some analysts are blaming the small number of funds who shorted volatility and have since blown up as volatility has increased. That may be a short term factor contributing to market declines but we think the real problem is that we are in a bubble which is supported by nothing more than speculative momentum.
Bob Hoye of Institutional Advisors, a market historian, has studied bubbles for many years. He writes that there have been five Great Bubbles since the invention of the stock market. These bubbles peaked in 1720, 1772, 1825, 1873, and 1929. Each was a mania that took years to develop and then crashed. Every great speculation runs until it climaxes. Throughout history, climaxes have had much in common, as have the consequent contractions. It's the "up" that causes the "down".
Hoye notes that each mania climaxed in the ninth year following the collapse of a great inflation in commodities. A financial boom followed the commodity boom. The commodity boom that peaked in 1920 was immense, as was its collapse. The South Sea Bubble topped in 1720, nine years after a commodities boom had climaxed in 1711. The same holds for the three bubbles in between. We also witnessed the collapse of a commodity boom that peaked and collapsed in late 2008, and here we are, about nine years later.
The financial bubbles that popped in 2000 and 2007 were not preceded by a commodity collapse nine years earlier. They also were not allowed to complete; the Federal Reserve and other central banks prevented the normal collapse by reflating the bubble with enormous monetary stimulus, first in real estate and then in the bond market. Quantitative Easing (QE) and Zero Interest Rate Policy (ZIRP) delayed the day of reckoning but the commodity bubble did not return. Do we therefore remain on the nine year clock? Is the current bubble following the classic model of Hoye's five Great Bubbles?
In the historical model, the high-flyers (Bitcoin?) crash first. Interest rates begin to rise. Note that the stock market rollover began immediately after long rates broke to new highs late in December. The psychology of the mania is replaced by risk aversion, credit spreads widen and the bubble pops. Today, spreads suddenly widened significantly. The unwinding process usually takes months to play out and more than a year to reach the bottom.
In the aftermath of a classic bubble, historically, gold and gold miners have been top performers. Will that happen again this time? We shall see. As investors start to realize that the Fed is now trapped, that it won't be able to respond to rising inflation by tightening aggressively due to a bear market in stocks, could we see gold explode to the upside?
We believe there is much to be learned from history. As students of the markets, we are also wise enough to know that anyone's thinking may prove to be wrong, including ours. We therefore present these ideas to stimulate questions; each of us must find our own answers.