Sizing Up the Bubble

“In the ruin of all collapsed booms is to be found the work of men who bought property at prices they knew perfectly well were fictitious, but who were willing to pay such prices simply because they knew that some still greater fool could be depended on to take the property off their hands and leave them with a profit.”

Chicago Tribune, April 1890

Presently, the broad NYSE Composite Index is at a lower level than it set more than 2 years ago, in July 2014. Including dividends, the index has gained hardly 2%. Several indices dominated by large capitalization or speculative growth stocks, particularly the S&P 500, have performed better, but even here, the index is only a few percent above its December 2014 high. Over the past two years, the behavior of the stock market can be described less as an ongoing bull market than as the extended topping phase of what is now the third financial bubble since 2000.

The chart below shows the current setup in the context of monthly bars since 1995. After the third longest bull market advance on record, fresh deterioration in key trend-following components within our measures of market internals (see Support Drops Away) recently joined this extended, overvalued, overbought, overbullish peak, even as the S&P 500 hovers at the top of its monthly Bollinger bands (two standard deviations above the 20-period average) and cyclical momentum rolls over from a 9-year high. Taken together with other data, we continue to classify present conditions within the most hostile expected market return/risk profile we identify.

The great victory of the Federal Reserve in the half-cycle since 2009 was not ending the global financial crisis; the crisis actually ended in March 2009 with the stroke of a pen that changed accounting rule FAS157 and eliminated mark-to-market accounting for banks (instantly removing the specter of widespread insolvencies by allowing “significant judgment” in valuing distressed assets). The victory was not economic recovery; the trajectory of the economy since 2009 has been no different than the trajectory that could have been projected using wholly non-monetary variables. No, the great Pyrrhic victory of the Fed has been to enable the third most extreme financial bubble in history, on the basis of capitalization-weighted indices, and the single most extreme bubble in history from the standpoint of individual stocks.

Greater fools

Every financial bubble rests on the presumption that there is still some greater fool available to purchase overvalued assets, no matter how overvalued they might become. In the recent half cycle, central banks have intentionally extended this speculation by promising that they, themselves, could be relied upon to be those greater fools. Yet despite the most extreme version of these assurances in Japan, where the Bank of Japan has driven long-term interest rates to negative levels and has purchased stocks outright, the Nikkei 225 index is no higher than it was in November 2014. Indeed, the Nikkei is no higher than it was 30 years ago, having lost more than -60% of its value on three separate occasions, two of them in a period when interest rates were pegged at zero, and never rose above 1%. Investors have been lulled into believing that an endless horizon of weak growth, easy money, and zero interest rates is desirable, when it is actually a syndrome of flat-lining vital signs.

What will drive the next crisis is not some rate hike by central banks (whose activist interventions have essentially zero correlation with subsequent real economic outcomes). Instead, the collapse will emerge both naturally and inevitably, as the progression of the economic cycle takes its course, and investor preferences shift from risk-seeking to risk-aversion. Virtually any commonplace shock is now capable of being a pin-wielding butterfly on this increasingly vulnerable financial bubble. Debt defaults, insolvencies, and pension crises are already unavoidable. Year-over year growth in real GDP, real gross domestic income, durable goods orders, real retail sales, industrial production and other measures are all down to levels typically observed at the beginning of recessions. We won’t pound the tables about imminent recession until we observe fresh weakness in the equity market (even a 7-8% market loss would sharply raise our probability estimates), but it’s important to recognize that financial risks are already fully developed, and as in other bubbles, one usually finds “catalysts” to blame for a collapse only well after the downturn is in full-swing.

The impact of central bank intervention has already weakened progressively in recent years, because it relies on the ability of fools to constantly raise the ante. Pay 82 euros today for a bond that delivers 100 euros a decade from now, and you’ll make 2% annually on your money. Pay 100 euros today and you’ll get a return of zero. Immediately following the Brexit vote, central banks tried to extend that game as global economic conditions weakened. Pay 105 euros today for 100 euros a decade from now, and you’ll actually lose -0.5% annually, but investors will still accept a negative yield in the short-run if they’re convinced the central bank is willing to pay an even higher price that produces an even more negative yield.