We would ignore all of the talk on Wall Street and in the
media about whether the stock market is in a bubble. After all, that’s just a matter of semantics,
and whatever we call it, the market is overvalued, overbought, and overly
bullish at a time when the economy is slogging along at an inadequate pace, and
depends almost solely on the prospect of continuing Quantitative Easing (QE) to
continue its upward move.
The market doesn’t have to be in a bubble in order for it
to be on the precipice of a significant decline. Of all the cyclical market peaks since 1929,
only the tops in 2000 and 2007 were looked back on as being bubbles. Most of
the other market peaks occurred with the P/E ratio ranging between 18 and 21
times reported cyclically-smoothed GAAP earnings, compared to a norm of 15
times and bear market lows between 7 and 10 times. At today’s market close the P/E ratio is 20.6
times earnings. That’s high enough to be
a potential market top, especially given existing fundamental and technical
conditions.
The market has been moving like a yo-yo in response to
the minute-to-minute perception of the prospect for Fed tapering. Yesterday, the market tanked after the
release of the Fed minutes indicated that a number of Fed members thought that
tapering should begin before a definitive improvement in the economy became
apparent. The specific paragraph that
got the market’s attention stated, “….participants also considered scenarios
under which it might at some stage be appropriate to begin to wind down the
program before an unambiguous further improvement in the outlook was underway.” Until this statement, most investors assumed
that winding down QE would only take place in a robust economy, and, therefore,
would actually be positive. The idea
that tapering could begin in the absence of real economic improvement was too
much for investors, at least in the short-term.
Today, however, when the Philadelphia Fed Survey released
results that were much weaker than expected, the 10-year bond yield abruptly
dropped, and stocks soared on the grounds that maybe the start of tapering
would be delayed after all. Such is the
state of the current market. Everything hinges on QE, and little else seems to matter. The similarity between now and 2000 or 2007
is not necessarily that we are in a bubble, but that the reason for market
strength rests on such dubious grounds.
In our view, the market is not supported by strong
fundamentals. The so-called strength in
the economy is based on forecasts, rather than on current conditions. But forecasts have now been overly optimistic
for the last three years, and we see no change in the period ahead. GDP has been growing at a 1.6% rate over the
past year. Similarly, real consumer
spending has been rising at a 1.8% rate, and real disposable income at
1.6%----and this with a powerful dose of QE.
With the rise in mortgage rates, housing has also become a weak
spot. October existing home sales were
down 3%, while the pending sales index, which leads existing sales, indicate
more declines ahead.
Technical conditions also point to a vulnerable
market. Breadth has been narrowing and
did not confirm new highs in the averages.
Daily new stock highs peaked in May and recently have been trending
lower. The Russell 2000 has been lagging
the large-cap averages. Some speculative
high-P/E momentum stocks have recently been hit hard. Tesla is down 37%, Cree 27%, Fleetmatics
26%, Facebook 15%, and Linkedin 14%.
Investors Intelligence bulls have averaged a historically high 54% and
bears 16% over the past four weeks, numbers indicative of market extremes. According to Vanguard, investors, as a group,
have a 57% allocation to equities, an amount exceeded only twice in the last 20
years----the late 1990s and prior to 2007-2009.
All of these numbers belie the belief that most investors are still too pessimistic.
All in all, we believe that the market is facing
significant headwinds, and that a major decline is not far off.
