"Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria." - Sir John Templeton
It is an important point that is frequently raised by investors in defense of the second longest bull market history. For all of its gains since the calming of the financial crisis so many years ago, we have yet to see the euphoric blow off top in stock prices that marks the end of a bull market. In fact, quite a bit of skepticism remains in this market today despite how far it has risen. As a result, we are nowhere near the extreme sentiment levels that would mark the end of a bull market. Thus, stay long stocks. If only it was that easy, for it is likely that the euphoria is already upon us. The key is knowing where to look for it.
Sir John Templeton is a legendary stock investor. And I believe his quote above is completely spot on. But a key question that must be raised in the application of the principles behind this quote is the following. Exactly how are we measuring the euphoria underlying a bull market at any given point in time. Is euphoria necessarily expressed in stock prices? Or can it be expressed in a variety of different ways that underlie the bull market?
Why exactly would any of these considerations matter? Because if your bullish and your sole reading for determining that we have entered the euphoric phase of an equity bull market is stock prices, you run the risk of getting blindsided when the bear has emerged from hibernation and is walking off with the value of your investment portfolio in its jowls.
Let's consider some recent examples by starting with a recent classic in the technology bubble. This was clearly a bull market whose euphoric phase was marked by rising stock prices. Or was it? Upon closer reflection, it was not all stock prices that were rising. Instead, it was the NASDAQ (NASDAQ:QQQ) driven by the technology (NYSEARCA:XLK) stocks and its related brethren in the media and telecom industries that had gone completely bananas to the upside. The rest of the market, on the other hand, was relatively mundane.
And if you were invested in major stock market sectors like consumer staples (NYSEARCA:XLP) and utilities (NYSEARCA:XLU), you were experiencing no such euphoria but were instead getting your head kicked in at the very same time that this supposed blow off top in stocks was taking place. Euphoria in stocks? No. Euphoria in tech stocks? Absolutely.
Let's fast forward to the next bull market ending in 2007. Not so long ago, but memories can quickly get fuzzy, like how the market supposedly collapsed immediately following the failure of Lehman Brothers (it was higher a week later and did not start falling precipitously until more than two weeks later).
So where was the euphoric, blow off top in stocks that heralded the onset of the major bear market from 2007 to 2009? Sure, stocks climbed from mid 2006 to their final peaks in mid to late 2007, but the move was hardly anything that would be considered frothy, particularly given the fact that stock valuations remained at or below their historical averages all the way up to the final market peak. So where was the euphoria? It wasn't in stock prices at all but instead was in home prices. For while national home prices historically grew between 5% to 6% annual since World War II, the spillover effects of persistently easy monetary policy during the bursting of the tech bubble helped create a house price euphoria of epic proportion that had home prices more than doubling over a brief six-year period including a more than 35% rise in less than two years time. Euphoria in stock prices? Absolutely not. Euphoria in home prices? Indeed.
So if its not in the broader market as measured by the S&P 500 Index (NYSEARCA:SPY), where exactly does the euphoria lie today? It does not lie in stock prices themselves, but instead in how much investors are willing to pay for each dollar of earnings from owning stocks, or more simply the price-to-earnings ratio. For while the S&P 500 Index has effectively gone nowhere since the end of 2014 on a price basis, the price that investors have been willing to pay for each dollar of earnings provided by stocks has soared by more than +30% over this same time period.
Such rapid multiple expansion is certainly not necessarily unheard of throughout market history. But it typically takes place either in the immediate aftermath of a bear market or when absolute valuations are well below the historical average in the 5 to 12 times earnings range, not at the later stages of a bull market when valuations were already relatively high. For Major League Baseball fans among us, it is the equivalent of an already great player suddenly seeing a sustained spike in production starting after age 35. This, of course, took place in several notable instances since the start of the new millennium, and none of those players appear destined for the Baseball Hall of Fame Cooperstown anytime soon despite their remarkable late career output. This is because it was eventually deemed that these results were being supported by false and artificial forces.
We have seen only three other instances over the past century where a comparable degree of multiple expansion from already high absolute valuations took place. These were 1928-29, 1986-87, and 1998-99. Two of these instances ended notoriously badly, the third resulted in the worst one-day decline in market history from which it took two years to recover despite the dawn of the Fed "put" era. Given that we are similar multiple expansion territory today that has led us to the second highest market valuations in history, it will be interesting to see how this fourth episode plays out.
What's Behind Today's Euphoria
But what is the driving force behind today's multiple expansion euphoria? The most likely culprit is the relentless expansion of global central bank balance sheets since the outbreak of the financial crisis nearly a decade ago. Overall, global central bank balance sheets have expanded from just over $5 trillion prior to the crisis in 2007 to nearly $18 trillion today.
What is particularly notable is that during past spurts of central bank balance sheet expansion from 2009 to 2011 and again in 2013 into 2014, corporate earnings were at least rising along with stock prices. This is in notable contrast to the latest round of global central bank balance sheet expansion. For today, stock prices may still be rising here in the U.S., but they are now sustainably falling across much of the rest of the world. Moreover, while rising earnings accompanied past stock price increases here in the U.S., earnings are no longer rising but instead have been shrinking for the past two years.
Put simply, we are likely already been in a euphoric phase for U.S. stocks for nearly two years now, not measured by stock prices themselves but instead how much more investors are willing to pay for an increasingly shrinking amount of earnings. Moreover, evidence is increasingly mounting that the monetary policy drugs that have delivered U.S. stock investors such a remarkable high over the past few years may no longer be working and in fact may just be making things worse at this stage.
So what is the pin that finally pricks today's multiple expansion euphoria? Presumably it is when this latest phase of global central bank balance sheet expansion starts to either flatten out or contract if not sooner. Although global central bank balance sheets continue to expand in aggregate, signs are growing that individual banks may be moving away from further asset expansion in the future. The Fed has been flat since 2014 and the People's Bank of China has contracted its balance sheet by roughly $750 billion since last year. On the flip side, the European Central Bank has been aggressively expanding its balance sheet by $1 trillion and counting since early last year after having contracted it by $1.5 trillion in two years prior, while the Bank of Japan continues to push the monetary accelerator through the floorboard with another +$1 trillion in balance sheet expansion so far in 2016. Given that earnings are already in decline and global stock prices have been falling outside of the U.S. despite this latest round of liquidity injections, any signs that the Bank of Japan or the European Central Bank may be thinking about changing course on their latest monetary policy strategies that to date have not been proving effective anyway, this may be just enough to finally begin deflating the rapidly growing valuation bubble here in the U.S.
Bull markets do indeed die on euphoria. But euphoria is not necessarily measured simply by stock prices. And when one goes back through stock market history, it is actually quite rare for euphoria to present itself through the so called "blow off top" in stock prices. Instead, euphoria tends to present itself in many forms that may or may not be reflected in stock prices. And today, it appears to be showing itself through the now rapid expansion in multiples in the U.S. stock market. For just as there was the belief in the "new paradigm" of technological productivity and the notion that "home prices always rise", today we have the claims that "there is no alternative" to U.S. stock prices regardless of valuation. These are all premises built on sand.
Stocks remain in a euphoric state. And there is nothing wrong with positioning to participate in this euphoria, as this is part of taking risk to generate returns. After all, who doesn't like to have their own share of fun at a raging party. But be careful out there, for dizzying euphoria is almost always followed by a headache filled period of sobering up. Enjoy the party, but don't overindulge and keep an eye on the clock and the exits. Such are the important principles of risk control in any market environment including today.
Disclaimer: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.
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.