Equity indexes in the U.S. have been posting a series of record high closes as investors anticipate a blue sky scenario this year. Trump will reinvent the American economy with his hoped-for tax cuts and deregulation. Yellen and the Fed will do just what is right for the economy and financial markets…even though FOMC members currently have no idea what to do. Companies will continue to "beat" analyst estimates with their heavily manipulated bottom line earnings. Of course all this great news for the market is fully reflected in equity prices today. Extrapolating future equity gains based on well-known public information is very characteristic near a market top.
Our hypothesis is that U.S. equities are in a bubble. We can only know in hindsight if this really is a bubble, but investors cannot be nonchalant faced with this real possibility. Looking at valuations, the historical divergences between the S&P 500 (NYSEARCA:SPY) price and aggregate S&P 500 EPS and operating earnings is astounding. The much circulated chart of Robert Shiller's CAPE price-to-earnings ratio shows valuations for U.S. equities at the third highest level ever (after the Tech bubble in 2000 and in 1929 just before the Great Depression). Going into the next correction with a naïve buy-the-dip mentality could be fatal for your portfolio if you are not prepared to manage risk.
This week we went back and looked at past equity market bubbles to get an idea of what to expect if we are indeed in the "Central Bankers' bubble". What makes equity bubbles so pernicious is the narrative investors are fed and their fixation of the everlasting truth regarding the reasons to be in equities. When equities finally fall, investors can't shake the belief that they should be buying. The prime example was technology in 1999-2000. Who did not believe in the tech revolution and the unlimited potential of technology in 2000? And eyeballs per click seemed like a reasonable valuation metric for tech companies without earnings, right?
We present six equity bubbles below: the run-up to the Great Depression, Japan in late 1980's, the tech bubble, the U.S. real estate bubble, the uranium bubble of 2007, and the China real estate bubble. On the charts we highlight the initial bust and the ubiquitous "dead-cat bounce" following the initial bust. Investors suffer universally from a cognitive bias called "belief perseverance". This simply means that investors cling too tightly to an opinion. More successful investors are able to abandon rapidly prior investment theses, whether they were true or not. Investors who cling too long to the reasons proposed to them to invest in equities end up eventually selling much too late.
Great Depression Stock Market Bubble (1924-1929)
The final phase of the equity bubble before the Great Depression reminds us a bit of the current market. For several months in 1929 it looked as if the market was topping out before the final explosion higher, akin to this "Trump rally" today. The initial drop from the peak was a swift -13% followed by a furtive +6% dead cat bounce. The rest, as they say, is history.
Japanese Nikkei Index (1986-1990)
The Japan Inc. bubble starting really inflating in 1986, but our chart zooms in on the last two years to see the topping process. Again we see a small initial drop of -6% and a small rebound of +3% before the real fun began.
U.S. Technology Bubble (1995-2000)
The final phase of the tech bubble was formed rapidly, in an inverse "V-shape" almost like a market bottom. As always, the initial selling was bought by investors suffering from belief perseverance.
Dow Jones Home Builders Index (2002-2005)
The real estate bubble took a longer time to top out following its peak relative to other bubbles. We again see an initial bust followed by a rebound of about one-half the magnitude of the initial selling.
Uranium Bubble of 2007
While not as high profile as the other equity bubbles the uranium bubble coincided with the significant rise in stock prices of companies mining uranium. The top was formed rather rapidly in two-weeks before about six months of choppy trading before the massive second wave down.
China Real Estate Bubble (2005-2007)
The China real estate bubble was spectacular in the speed of the run-up and the bust. The chart below shows the CSI Shanghai Real Estate Index. The initial bust was much deeper at -27% while the rebound was very tradable, offering up a +23% move.
No two bubbles will unfold in the same manner, but a common feature of all is a quick initial move down with at least one opportunity to get out on a rebound. Only the Tech Bubble saw a rebound that approached the peak of the bubble. For those looking for a correction to buy today, don't get too comfortable if you buy and the S&P 500 rebounds sharply after the correction. With exaggerated valuations in the second longest bull-market on record, this is not a time to be complacent.
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.