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Valuations are not currently indicative of bubble conditions in the U.S. equity market. Whether one analyzes the U.S. equity market based on trailing or forward earnings, the S&P 500 index at 1,700 is within one standard deviation of its long-term average (albeit at the upper end of that average). The valuation of the Dow Jones Industrial Average is similarly situated within normal parameters.

However, as my regular readers know, it is my view that conditions are ripe for the formation of an equity market bubble in the course of the next year or so. Readers who wish to follow my reasoning can consult the following:

Why A Stock Market Bubble Is Forming Right Now

Beware Long-Term Damage From Stock Market Bubble Forming Now

A Bubble Continues To Form In The Stock Market

Can Fed Put Rate Genie Back In Bottle, Keep Bubbles Corked?

Bubble Backdrop

Throughout history, asset bubbles have had different causes, have emerged from different conditions and have taken on different shapes and forms. The conditions that provide the backdrop for the potential bubble I have been describing in the past few months can be summarized by two critical factors: Monstrous quantities of excess liquidity in the economy and steadily declining liquidity preferences.

It is critical to understand that neither tapering nor the eventual termination of QE will prevent the formation of massive asset price inflation. The reason is that once QE is finally terminated, the excess liquidity will remain in the system. In the context of a fixed quantity of liquidity at abnormally high levels, normalizing (i.e. declining) liquidity preferences will imply quickening transactional velocity, meaning that the existing liquidity in the system will simply be employed with increasing frequency for transactional purposes, placing upward pressure on the prices of certain types of goods, including investment goods. As individual and households attempt to draw down their liquidity balances via purchases of consumer and/or investment goods, it is a fact that it is impossible for them to do so on aggregate. Thereby, liquidity increasingly becomes a kind of "hot potato" for households and businesses, and in the process, the value of liquidity will tend to decline relative to certain types of goods and services that are in high demand and relatively limited supply.

Furthermore, it is possible that even with a constant stock of base money, overall liquidity could rise further via credit creation in the banking system. This would imply a sort of inflationary "double whammy" whereby rising transactional velocity is also accompanied by an acceleration of "inside money" creation, fueling further transactional activity.

What Will The Bubble Narrative Be?

The formation of systemically important asset bubbles is a sort of social phenomenon that usually coincides with some sort of exciting narrative about a brave new economic future. Whether it was the South Sea Bubble, or the New Economy, asset price bubbles need a plausible story-line to catalyze manic-type behavior.

I am not sure what narrative or narratives will emerge this time around. Perhaps it will be a narrative connected to shale oil and gas and the projected energy independence of the USA, which would be reflected in domestic E&P stocks such as Chesapeake Energy Corporation (NYSE:CHK) or MLPs such as Kinder Morgan Energy Partners (NYSE:KMP). Perhaps it will be connected to alternative energy opportunities represented in stocks such as First Solar (NASDAQ:FSLR) and the companies held by ETFs such as (NYSEARCA:TAN). Perhaps it will be connected to various forms of clean-tech companies such as Tesla (NASDAQ:TSLA) or the ones that comprise ETFs such as PowerShares Global Clean Energy (NYSEARCA:PBD). Maybe a bubble narrative will form around emerging pioneering technologies such as 3-D printing being developed by companies such as 3D Systems (NYSE:DDD) or advanced robotics being driven by companies such as iRobot (NASDAQ:IRBT). Or an over-arching bubble narrative could emerge that incorporates all of the above.

Whatever the narrative is, it will be about "transformation," and "revolution," in contrast to the dreary "new normal" narrative that has dominated the media for the past five years.

What About The Shut Down and Possible Default?

It might seem strange that I am talking about a potential surge in economic optimism and a concomitant stock market bubble at a time that the terms "default" and "shut-down" are all the rage in the financial media. So let me explain why I have not been emphasizing these threats in my outlook for financial markets.

First of all, default is not a serious threat. Asides from the fact that the U.S. Congress will almost certainly raise the debt ceiling when push comes to shove, the fact of the matter is that the threat of default is mostly imaginary. The U.S. Treasury has both the ability and the constitutional obligation to prioritize debt payments. So, even though Treasury Secretary Lew has recently tried to discourage discussion of this recourse for political reasons, the fact of the matter is that the U.S. Treasury has sufficient revenues to cover all interest payments and a virtually infinite capacity to roll over existing debt (unlimited capacity for Fed to purchase Treasury securities). Default is neither a real choice nor a serious possibility.

Second, for all intents and purposes, a government shut-down (a matter that is entirely distinct from a potential debt default) will only delay economic growth - it will not seriously diminish it on a long-term basis. A government shutdown could become relevant if it lasted several months and affected more personnel and government functions than it does currently. However, I consider such a scenario to be relatively remote. Under most reasonable scenarios, a slow-down in one or a few months involving non-essential government personnel will simply push economic activity into succeeding months. Therefore, a government shut-down is essentially a non-issue from a macroeconomic point of view.

A Pause In The Formation Of A Bubble

Stocks have been rising at an explosive pace since November of 2012. For example SPDR S&P 500 (NYSEARCA:SPY) has has risen by 22% since November 15, 2012, while the SPDR Dow Jones Industrial Average and the PowerShares QQQ (NASDAQ:QQQ) by 18% and 24%, respectively. So the talk of shut-downs and default have served as a convenient excuse for the stock market to undergo a bit of overdue technical consolidation.

Still, considering the magnitude of the preceding rally and the nature of recent shocks related to Fed tapering, government shutdown and default-talk, I consider the shallow and brief nature of recent corrections to be important confirmations of the market's bubble trajectory.

I still think the market could see the mid 1500s or even the high 1400s before all is said and done with the brinkmanship in Washington D.C., coupled with the uncertainties surrounding Fed tapering. However, I believe that such a correction would represent a relatively minor development in the context of the broader underlying phenomenon of asset price inflation that seems to be under way.

Conclusion

Don't get too carried away by the drama about government shutdowns and a potential sovereign default. The real story is the asset bubble that is developing, fueled by excess liquidity and declining liquidity preference.

Source: A Stock Market Bubble Is Still In The Cards