Irrational Exuberance: Episode 4

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Includes: DIA, IWM, QQQ, SPY
by: Kevin Wilson

Summary

We are in the third serial stock bubble, and the fourth iteration of irrational exuberance, since 1995.

Stocks have tripled since 2008, creating similar downside risk to that experienced after the 1990s tripling of stocks during the tech boom.

The combination of increased investor risk aversion, the apparent elimination of the Greenspan-Bernanke-Yellen Put, extreme valuations, and the commodities meltdown bode ill for the markets.

The stock markets in many countries reached all-time high valuations in early 2000, but then dropped by about 50% during the two-year period after their peaks in early 2000. The collapse of the global stock markets was followed almost immediately by the onset of a global housing boom, which then peaked in 2005 or 2006. Additionally, a global commodities boom began in 2002 and did not peak until 2011 in spite of several episodes of hyperbolic price increases and a sharp pullback in 2008. This boom was out of phase with the others to some degree. Finally, a massive credit bubble was inflated over the years from 1995 onwards, and reached enormous proportions by 2007. It then collapsed in a series of crises initially related to the demise of sub-prime mortgages accumulated in the frenzy of the housing boom. This culminated in the near-collapse of the global banking system, which was halted by the draconian measures taken by central banks and governments to save the system in 2009. The system as it were was saved, but fervent vows to fix it have been so much lip service. Debt has grown worldwide by another $57 trillion (!) since 2008. Now we appear to be in yet another credit-enhanced bubble in some markets, making this the third serial stock bubble, and the fourth iteration or episode of "irrational exuberance" since 1995. It seems prudent to revisit what our downside risks might be.

Each of these booms eventually reached or will reach the level of a speculative market bubble, a level characterized by Nobel laureate Robert Shiller of Yale University as a type of "irrational exuberance." The phrase was coined by former Fed Chairman Alan Greenspan in December 1996, three years before that particular market bubble finally peaked. Shiller famously published a book on the subject in 2000, and published a second edition in 2005 (Robert J. Shiller, 2005: Irrational Exuberance, 2nd Edition, New York, Currency Doubleday/Random House, 304 pp.). These and other speculative bubbles may be described as situations in which temporarily sky-high prices are sustained by investors' enthusiasm and greed rather than by any reasonable estimation of asset fair values based on fundamentals. Speculation is simply defined as investing in assets such as stocks or real estate for the sole purpose of reselling at a higher price (also known as the "greater fool theory"). The great economist Hyman Minsky would have described this speculative activity as Ponzi finance. Shiller maintains that irrational exuberance is the psychological basis of each new speculative bubble that comes along. He identifies the 1990s stock (Episode One) and the 2000s housing/stock (Episode Two) bubbles as major examples, but I would add the somewhat overlapping or out-of-phase commodities boom (Episode Three) to the list as well. And if the current market behavior is any guide, we may soon see that we have been in another stock bubble (Episode Four), when it collapses at some point in the near future.

As an example of its type, the speculative bubble of the stock markets in the late 1990s may be the biggest in history. The Dow Jones Industrial Average (DJIA) stood at about 3,600 in early 1994. By March 1999, it passed 10,000 before peaking at 11,723 on January 14, 2000, having tripled in just five years. Basic economic indicators like GDP (up 40%) and corporate earnings (up about 60%) couldn't justify this tripling in price, and market valuation parameters such as the P/E ratio were by far the highest in the market's 130-year history. Shiller's calculation of P/E is based on the aggregate price/10-year average earnings of the S&P 500, termed the Cyclically Adjusted P/E, or CAPE. In spite of averaging earnings over a decade, Shiller's P/E still rose to a high of 47.2 on March 24, 2000, the highest reading since 1880. The next highest reading for P/E since 1880 (up to that point) was in September 1929, when the ratio was 32.6, right before the Great Crash. For reference, the long-term average for CAPE is 16.6, and the current level is 26.2. The bursting of the bubble in 2000 was accompanied by the biggest bust in corporate earnings since 1921, which no doubt removed some support for the then-current notion that the new high-tech economy was invincible.

Shiller thinks that a number of factors contributed to the inflation of the stock market bubble in the late 1990s. Several of the factors may have general application to understanding other bubbles as well. For example, the increasingly capitalist society we live in has made many people feel as if they are being treated as mere commodities in the game of global commerce. Shiller suggests that speculative investments in stocks and houses made people feel more secure because they felt that the value of their investments was more enduring. There were also the contributing factors of media hype on cable networks such as CNBC, and outrageously optimistic forecasts from stock analysts. Zacks Investment Research has shown that out of 6,000 companies analyzed in late-1999 (near the market peak), only 1% received sell recommendations while 69.5% got buy recommendations. This was eventually reported as the scandal that it deserved to be called.

Shiller also refers to a contributing factor that is grounded on what he calls a naturally occurring Ponzi scheme. This is the notion that stocks are the best investment at all times, and therefore investors can't really go wrong if they put all their money in stocks. This may have contributed to the huge numbers of people who bought at the top in spite of already sky-high prices. I personally remember meeting an investor about six months before the Enron scandal broke, who asked me whether I would recommend the stock. At the time, Enron's P/E ratio was about 65, which I pointed out meant that at least the next three years of presumably record earnings had already been discounted by the market. It was too rich for me. Even asking the question, I was asked really constituted prima facie evidence of a belief in Ponzi finance, i.e., that buying high in a bubble can somehow make sense. Of course the ensuing meltdown of Enron and the simultaneous 50% drop in over-all stock prices demonstrated the fallacy behind this get-rich- quick idea.

Another factor favoring the inflation of the 2000 stock bubble was the so-called "Greenspan Put". This was the notion that the Federal Reserve was so supportive of the stock markets that it would prevent a major selloff from occurring, in effect providing investors with a put option to protect their investments from stock market declines. Although the bubble did eventually burst, some aspects of the Greenspan Put did operate as expected. When the recession of 2001 began, the Fed lowered rates aggressively, leading to the biggest one-day gain (14%) on the NASDAQ ever. But the Greenspan Put did not prevent an eventual 50% drop in the markets, as economist John Hussman has pointed out. Rates continued to be cut until 2003, eventually bottoming out at a mere 1% and staying there for many months.

Many observers believe that this loose monetary policy is exactly what led to the inflation of the historically massive housing bubble (Episode Two). The commodity bubble (Episode Three) started around 2002 during this same extended period of low rates. There was much critical commentary in 2008 from economists like Brian Wesbury that then new Fed Chairman Ben Bernanke had renewed the Greenspan Put with his own "Bernanke Put." Once again, the Fed's put option under the market supported speculation, but did not prevent a collapse. After the Great Financial Crisis, one would have expected this super-accommodative Fed policy to have been repudiated, but it instead continued for years more. There were criticisms as late as 2015 that new Fed Chair Janet Yellen effectively renewed the Bernanke Put with her own "Yellen Put," by refusing to raise rates above zero for a cumulative total of seven years. Now that she has finally raised rates by a quarter-point, perhaps the era of Fed puts under the market is over. But I'm not counting on that, because the philosophy behind it has apparently not yet changed.

During the global housing bubble's inflation, real home prices for the entire U.S. increased by over 60% between 1997 and 2006. When the market peaked in 2006, the dollar volume of single-family home sales relative to GDP was at least 25% higher than any housing boom since 1968. The naturally occurring Ponzi scheme that was associated with the stock bubble was almost certainly transferred to the housing market bubble intact. Stories are legion of speculative investors buying condos in all the hot markets at hugely inflated prices in 2005 and 2006, right at the peak. There was an entrenched belief that "you can't go wrong in real estate," or that "they're not making land anymore," implying that there was no place to go but up. The sorry tale of sky-rocketing foreclosure rates, millions of vacant homes for sale, and plummeting home prices (more than 30% drops in CA, AZ, FL, GA and NV) puts the fairy-tale about real estate in perspective. Obviously there was some irrational exuberance associated with the housing boom, probably for many of the same reasons. The psychology involved should be familiar, since stock and real estate bubbles have been twins since at least the 1600s, according to Shiller and his mentor Charles Kindleberger (Mania, Panics, and Crashes: A History of Financial Crises, 4th Ed., 2000, New York, John Wiley & Sons, 290 pp.).

The concurrent and longer lasting commodities boom had several episodes of hyperbolic price increases for individual commodities such as wheat, corn, nickel, copper, natural gas, oil, platinum, and uranium. In each case that particular commodity eventually corrected or sold off, to be replaced in bubble territory by yet another commodity. The meltdown of 2008 did not end this boom, however. Renewed rallies in various commodities continued after the huge stimulus spending by governments kicked in during the GFC, finally reaching their culmination in 2011, which was the apparently final peak for many major commodities. Recently renewed collapses in oil, natural gas, iron ore, copper, lumber and a wide range of agricultural commodities have involved catastrophic losses, and suggest that supply and demand have become completely unbalanced as a result of over-investment or mal-investment in excess supply. Much of this most recent collapse can be laid at the doorstep of China, whose spending on mal-investment projects has been unprecedented in modern history. These years of Ponzi finance and mal-investment in China led to unprecedented overcapacity, and ultimately to a collapse in commodity imports that has had knock-on effects around the world.

There has been some lively debate recently about whether or not the current bull rally is really a bubble. Jeremy Grantham of GMO has suggested that it's not technically a bubble until the S&P 500 reaches the level of 2250, or two standard deviations. However, at the recent peak of 2134, we were only 5% below that level. And many others have noted the historically high valuations currently posting for the markets. For example, on an EV/EBITDA basis, markets are at the second highest valuation in modern history, according to Albert Edwards of SocGen. On a median stock basis, valuations on market cap/GVA are the highest ever, beating even the 2000 record, according to John Hussman. On a Price/Sales basis, stocks are also at extreme high valuations, again rivaling the levels of 1929, 2000, and 2008. And on a CAPE basis, the valuation is the third highest ever. In my book, this is a valuation bubble, driven not so much by psychology as by the forced pursuit of yield in a ZIRP world controlled by the Fed.

But can stocks go even higher? Of course they could, but only under certain conditions. These would have to include a recovery from extremely narrow breadth, and higher yield spreads, both of which signal risk aversion. As John Hussman says, widespread evidence of risk aversion tends to put an end to extreme stock market valuations, and the downside can be enormous once such a combination of circumstances appears. There are other reasons why the bull market rally may not have much gas left. For example, the mania that drove stocks (especially tech stocks) higher in the 1990s doesn't seem to exist this time around; i.e., there is no great narrative that has captured the public's imagination this time. Many retail investors never bought in to the long rally, and equity mutual funds saw massive withdrawals throughout the last six years. And the Federal Reserve, after aiding and abetting a bubble for years, just as they did in the late 1990s, has more recently tried to talk it down this time, and has even raised rates at an arguably bad moment to do so.

This most recent credit and stock bubble has resulted from the extended period of zero rates the Fed put in place to combat the Great Financial Crisis of 2008. For the third time in a row, the Fed has kept rates too low for too long, and the fourth Fed-induced asset bubble has been inflated. The low growth environment of the recovery, combined with zero rates has led to a huge portion of the corporate credit used in the last few years being spent on buybacks and dividend financing rather than capex. This has resulted in underinvestment by many corporations, and huge inflation in asset prices. That underinvestment is now coming home to roost, with profit margins beginning to mean revert, and organic earnings growth stagnant or falling in most industries.

The long period of low rates permitted many zombie companies to be created, kept living only by virtue of cheap financing and easy money. The sudden surge in high yield distressed debt and corporate bond spreads indicates that the party may be winding down now. The weaker housing data of late suggests that all of the components are present for an unpleasant surprise for the markets, assuming economic data continue to deteriorate and risk aversion continues to climb. As someone said some years ago, these asset bubbles take a long time to inflate, and will generally take a long time to deflate as well. So if you've learned anything at all from the previous three episodes of irrational exuberance, you'll consider selling the rallies into 2016, and start preparing for stormy weather ahead.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended.

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