Bubble Stage Of This Bull Market May Be Nigh

Includes: DIA, SPY
by: James A. Kostohryz


We are not a in a bubble yet, but conditions for the formation of a bubble are increasingly propitious.

As indicated in previous writings, the end of QE may mark the take-off point for the bubble phase of this bull market. I confirm that view and expand on it.

The recent FOMC statement and Chair Yellen's press conference remarks suggest that monetary conditions will remain extremely accommodative for a very long time. I review the implications.

I been very clear in my Seeking Alpha writings on the subject of "bubbles" that I do not believe that any portion of the stock market advance from March of 2009 until now can be properly characterized as a "bubble." In support of this view, I have shown that while stock market prices on aggregate - as represented by major indexes such as the S&P 500 (NYSEARCA:SPY) and the Dow Jones Industrial Average (NYSEARCA:DIA) - are historically expensive, the most appropriate and reliable measures suggest that valuations have not yet risen to levels that would be indicative of a bubble. In the same vein, I have argued that several critical elements of a stock market bubble have been missing such as widespread enthusiasm about economic and financial conditions.

Keeping these facts in mind, since last year I have also been writing about the evolution of specific conditions that are propitious for the formation of stock market bubbles. Furthermore, in my most recent writings, I have suggested that a plausible time frame for a bubble phase of the current bull market to develop will be immediately before, during and after confirmation of the ending of the Fed's Quantitative Easing (QE) program. Specifically, I have argued that once the uncertainty over the end of QE has been lifted and there is greater visibility regarding the extent and timing of the Fed's normalization of short-term interest rates, stock prices may begin to discount the profound implications for asset prices that the extraordinary levels of excess liquidity in the US economy have under present conditions of normalization of risk aversion and liquidity preferences.

In this context, the most recent Federal Reserve Open Market Committee (FOMC) statement, and subsequent press conference by Chair Janet Yellen, may prove to be the sort of landmark event that I have adumbrated.

Highlights And Analysis of Fed Statement and Yellen's Press Conference

I think there were three elements in the FOMC committee statement and in Yellen's conference that are worth highlighting in this regard:

1. Extension of "considerable time" calendar guidance. Contrary to the expectations of many market participants, the FOMC retained the "considerable time" calendar guidance. At the press conference, Yellen explained the decision to affirm this description of the amount of time that is likely to elapse before the Fed makes its first rate hike saying that, "the outlook hasn't changed that much from June, and the committee felt comfortable with this characterization…" This manner of framing the issue suggests that something significant will have to happen for the Fed to lower its assessment regarding the amount of time that will transpire before the first rate hike. This implies that despite a rate of economic growth that has approximated 4% in the latest quarter and the one ongoing, the amount of time that will elapse until the first rate hike could be considerably more than the roughly six months (from the end of QE in October) that the market has been expecting.

2. Humanistic emphasis on conditions of "extraordinarily vulnerable." In the press conference, Yellen doubled down on making her focused concern with the plight of the poorest Americans and the human toll associated with current economic conditions a matter of Fed policy. She cited the "extraordinarily vulnerable position" of many American families, in somewhat "humanistic" or even emotional terms characterizing their plight as "sobering." This emphasis on human empathy is unique in Fed history and is significant because it suggests that in the face of such urgent human circumstances, the "burden of proof" will probably be on those within the committee that wish to raise rates. This suggests that in the absence of very clear evidence that the Fed's inflation mandate is being demonstrably jeopardized, the Fed will exhibit a significant bias toward leaving interest rates low until the full employment objective is met - and in particular until the conditions of the nation's most vulnerable families are significantly improved.

3. Balance sheet accommodation "until end of decade." I think this may have been one of the most telling statements. It highlights the fact that the end of QE only ends the expansion of the Fed's balance sheet - it does nothing to normalize it or end the accommodation being provided by its extraordinary size. In regard to the time she expects for the process of balance sheet normalization to be completed and therefore accommodation through this medium to be ended, Yellen indicated that she expects that "it could take to the end of the decade" for it to be completed.

I think that there can be little doubt that the general impression left by the combination of the FOMC statement and Chair Yellen's press conference is that Fed monetary policy will remain extraordinarily accommodative for a very long time. Interest rate normalization will not even begin until a "considerable time" has elapsed, and by implication, interest rates will remain significantly accommodative for a considerable amount of time even beyond that. Furthermore, accommodation via the Fed's balance sheet expansion will probably remain in place until the end of the decade.

Bubble Phase Of Bull Market May Be Nigh

As I have stressed in my prior writings, and in an extensive interview (which I highly recommend for those of you that want to understand the impact of the end of QE), that the effects of the Fed's balance sheet expansion will be felt long after QE officially ends. The reason is that the excess liquidity injected via QE remains in the system. No amount of stock purchases by investors and/or no amount of market price increases will reduce the amount of liquidity that is in the system. When one person purchases stock, the cash paid by the buyer merely goes into the pocket of the seller, who then has to decide how to dispose of that cash. As the US economic recovery consolidates - very much as I predicted in my 2014 Economic Outlook - risk aversion and liquidity preference will decline. This means that households and businesses will spend their available liquidity more quickly than before - i.e. their perceived need and desire to hold excess amounts of cash will be reduced.

US households and businesses have accumulated unprecedented amounts of cash. A decline in liquidity preference means that they will tend to want less cash relative to other goods that they can buy with that cash. But this creates an irony: Since the total amount of cash in the system cannot be reduced by any amount of increased spending by households and businesses, the only thing that can happen is an increase in "transactional velocity" - i.e. people's typical holding period for retaining a given amount of cash decreases progressively thereby quickening the aggregate rate of purchases in the economy.

The question is: What will they purchase? The answer is that the vast majority of households and businesses, more so than increasing their level of consumption very significantly, will most likely increase their purchases of investment assets, and increasingly riskier financial assets (such as stocks) in particular. This will increase the "transactional velocity" of purchases in financial markets that, in turn, will tend to fuel asset price inflation. This occurs because as liquidity preference decreases, the concomitant tendency for investors to buy "at the market" and "take the offer" increases and they do so more frequently, a process that naturally tends to drive prices upwards.

This dynamic, once started, tends to replicate itself in a feed-back loop, increasing transactional velocity even further whereby higher financial asset prices produce an even greater demand for financial assets by people that want to "get in on the action" or at least "not get left behind." This sort of feed-back loop is a critical element in the development of a stock market bubble.


Nobody fires a gun to announce the start of a bubble phase in a stock market advance. Furthermore, nobody rings a bell right before a bubble collapses. Having said that, it is also a fact that the processes by which financial markets bubbles develop are theoretically and empirically intelligible by experienced and astute traders and investors.

In this regard, I have noted in this article that the current environment contains many of the ingredients that are propitious for the formation of a stock market bubble. In particular, present monetary and financial conditions are near ideal, and the recent statement by the FOMC accompanied by Chair Yellen's press conference suggest that these conditions will remain in place for a very long time. Indeed, in retrospect it may be possible to look back to September 18, 2014, as a key date in the development of the next bubble phase in the US stock market.

We are not in a bubble yet. Some ingredients necessary for the development of a stock market bubble, such as greater economic optimism, are as of yet lacking. Furthermore, the sort of widespread speculative appetite associated with financial bubbles is not present. However, these missing factors have shown tentative signs of emerging and the likelihood that they will fully manifest will only grow as the present economic recovery proceeds at a relatively vigorous pace. The most recent NY and Philly Fed reports confirm the gathering momentum of economic recovery that I indeed foresaw in my 2014 Economic Outlook.

If these economic and financial trends continue apace, a full-fledged stock market bubble is likely to emerge. To be clear, this implies significantly higher prices from here. To also be clear, it is implicit in the use of the term "bubble" that, at some point in a more distant future, most of the bubble gains that I'm vaticinating will likely be wiped out. However, this eventuality of a "crash" does not occupy me now. For now, the most important message that I want to get across to investors is that the most likely trajectory for stocks in the next one to two year time frame is significantly higher. How much higher? Bubble higher.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.