Convincing Traits Of A Market Bubble - Part III (Conclusion)

by: Mark Bern, CFA


The Trump Effect is driving investor enthusiasm.

The Fed Put has made investors feel invincible.

The ETF Impact is driving large capitalization stocks higher regardless of fundamentals.

Investor Sentiment has again risen to irrational levels.

Do not let this be you!

In Part I of the three-part series I covered in detail how stretched the current market valuations and multiples are compared to historical norms. I also provided graphic evidence that exhibits how the markets have only attained these levels once or twice (depending on the indicator examined) since the Great Depression and Crash of 1929. Finally, in that article I also exposed the fact that true, unadjusted earnings for the S&P 500 are still below the 2007 and 2011 points, yet the index has risen by nearly 89 percent since 2011. This raises the question of what were investors paying for if not future earnings? We are now more than five years into the future but earnings have actually fallen over that time.

SPY Chart

SPY data by YCharts

In Part II I focused primarily on the excessive levels of debt that has accumulated globally, especially since 2008, just before the last financial crisis. I also tried to explain the potential hazards of the globally connected financial network, increased levels of derivatives since 2008, and how major banks in Europe may actually be in much worse financial condition now than before the financial crisis. In that article I discussed how interest rate increases by the Fed eventually end and, while not generally the direct cause of recession, how we usually find ourselves in a recession at or near the peak of Fed tightening trends. Finally, I looked at the Buffett indicator, Market Cap to GDP and found that it, too, was at nose-bleed levels.

I want to assure readers that none of these articles is meant to stand alone as providing convincing evidence as to whether or not the market is trading at bubble valuations. However, taken as a whole, I believe the arguments contained in all three articles make a good case that we are experiencing the third bubble in less than two decades. With that I would like to move on to my third set of evidence: investor sentiment or, as I would call it at this point, irrational exuberance. Let's take a look at a few factors that are driving this market even higher and put them into historical perspective.

The Trump Effect

Obviously, many investors who had held cash on the sidelines have entered the market since the election. They expect miracles out of Washington, D.C. Who could argue with that? Well, um, has anyone ever really seen miracles come out of that place before? This time will be different! I believe I heard that near the last two market tops, too. I have no doubt that the new Administration is trying to accomplish as much as possible as soon as it can. What I do have my doubts about are how fast it will be able to get things passed through the Legislative Branch (Congress) and whether its promises will not get watered down. Congress has a way of spoiling the economic party and I see no reason to expect this time to be much different. But I do not want to dig into the politics of the situation. I just question how reasonable it is to expect all the problems to get solved at once or even within the first year. It seems to me that the market is priced for a huge tax cut within the next few months. We shall see how long the enthusiasm continues if the process gets bogged down.

My first graph shows the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) from December 1, 2007 to October 1, 2016. Notice that from March 9, 2009 to December 1, 2016 the value of the ETF shot up from $67.10 to $216.30, or a gain of 222 percent in just seven years and almost eight months. That works out to compound annual growth of 16.5 percent. For those interesting is such things the formula for that calculation is =((216.3/67.10)^(1/7.67))-1 if you are using an EXCEL spreadsheet.

SPY Chart

SPY data by YCharts

Now I want you to consider what happened from December 1, 2014 to November 1, 2016. SPY went from a price of $207.20 in 2014 to close at $208.55 on November 7, 2016. That means the SPY went nowhere (actually up a whopping .65 percent) for the last almost two years of the bull market. Then what happened? The election outcome that nobody expected. Followed shortly thereafter by a euphoric market response. Before the election the bubble was lacking something. Now look at the SPY graph from the end of December to its current value.

SPY Chart

SPY data by YCharts

There it is! What was missing was the "dumb money" entering the market. That is what tends to happen during the final stage of a bull market. Small investors seem to suddenly lose their memories of the last two bubble market crashes and flood into the markets by the droves. A bull market run rarely ends out of gas until this last stage has taken place. The small investor, who previously has remained too heavily in cash and has missed out on the easy money to be made suddenly has a change of heart and starts buying hand over fist. What happened? Trumponomics and the promises of a new presidency to drain the swamp, make America great again, bring back jobs, close the borders, lower taxes and invest in the nation's infrastructure all at once. It may happen in time, but those investors seem to believe that corporations will become wildly more profitable this year. The problem is that it may take longer. We shall see.

But small investors coming back into the market is not a good sign of a new, resurgent bull market, in my opinion. The small investor is usually wrong. And I believe that the euphoria surrounding the Trump effect will wear off it change does not come soon enough. However, I must add that such euphoria can last longer than seem imaginable. In the late 1990s and into 2000 the same crazy sort of valuations just kept getting crazier month after month, year after year, until the bubble popped. Everyone was invested back then because no one wanted to miss any more of the big gains that had been occurring for so many years. It happened again in 2007 and I believe it is happening again now. But it is impossible to foretell just how long it will continue to happen.

The Fed Put

There has been a sense in the investing community for several years now that the Fed (U.S. Federal Reserve Bank) has our back. As long as the Fed is willing to support asset prices the markets cannot fall. I have some bad news. The Fed can only support prices as long as there is ample confidence in its ability to do so. How much more can the Fed do?

The Fed understands that it risks losing control of the economy and that it must reload its ammunition belt before the next recession strikes. There are two steps to this process. First it must raise interest rates to more "normal" levels (a term that is extremely subjective and will depend on Fed discretion). Next it must reduce its balance sheet to give it more flexibility to use QE (quantitative easing, or buying assets with money created out of thin air; don't you wish you could get your hands on that goose?) Those are the Fed's two most important weapons to lessen the negative impact of the next recession. Until it accomplishes those two efforts it has less ability to actually support asset prices.

It must do one before the other because doing both at the same time could create too much drag on economic growth. It has chosen to increase interest rates first. I expect that once it determines that it has done enough in that area to give it some leeway, should another slowdown occur, it will begin to reduce its balance sheet. I expect that effort to take years to complete as doing so too aggressively could such too much money out of the system and cause credit to tighten, again causing a drag on economic growth.

The point I am trying to make here is that the Fed is really in no position to do much about supporting asset prices were it to become necessary. I do not expect investors to figure this one out without having to live through the experience if a recession occurs before the Fed is ready for one. Then it could become painfully obvious, especially after the fact. How much time does the Fed have to reload? I do not have a clue, nor do I suspect anyone else does either. I am concerned, though, that it could very well take longer than the time we have left.

This is not to say that the Fed will in any way cause a market crash or recession. It simply means that I do not believe that the Fed is in a position to do much to maintain the confidence it requires to be effective at the present time or that it will be properly positioned anytime soon. This process could take years.

The ETF Impact

ETFs (exchange Traded Funds) have become all the rage over the last few years, especially in the last two. In 2016, ETFs containing domestic securities have experienced net asset inflows of over $426 billion. At the end of 2016 the total domestic ETF AUM (assets under management) totaled $2.54 trillion. In the first two months of 2017 domestic ETF inflows totaled more than $30 billion as global inflow to start the year set a record. There seems to be a sense among investors that by using ETFs, especially those that mimic broad market indices, are safe. If held long enough, that assumption may be correct. ETFs also provide greater liquidity than mutual funds so that an investor can get out a position quickly if needed.

However, for those investors who believe that buying ETFs and forgetting about them is a sound strategy a day of reckoning is always just around the corner. They may believe that they have the intestinal fortitude to hold on for the long term knowing that these ETFs will eventually recover from any major selloff, but the sad truth is that when the market begins to crash emotions take over and fear drives small investors out of the market. It has always happened in the past and I have no doubt it will continue to happen again and again in the future. It is human nature to panic in such circumstances.

To amplify this effect will be the computer driven hedge funds using algorithms based upon regression analysis piling into the market following the momentum. The doors will narrow for those trying to sell as the crowd rushes toward the exits all at the same time. Panic and fear drive irrational behavior among the small investors. And those momentum driven computer trading systems take advantage of the situation.

"All of the money is going into the cheapest and most boring ETFs. This is the retail investor getting back into the market with a vengeance," - Dave Nadig, chief executive of

To illustrate this concept just take a look at the chart below from The Wall Street Journal at

A lot of money is flowing into the large capitalization companies of the S&P 500 Index and the Dow Jones Industrials Average (NYSEARCA:DIA). The purchase of index-based ETFs are driving the indexes to all-time highs. It does not matter one iota if there is fundamental support.

Fundamentals do not matter in a Bubble

The biggest stocks in the market-cap weighted S&P 500 just go up regardless of operational performance. Let us take a look at a few of the well-known examples. Apple (NASDAQ:AAPL), with a market cap of $734 billion and trading at a P/E of 16.8, is one that I own for the income and because of its strong cash flows. I believe it will get taken down in a market crash but also believe that it will rebound more quickly than many other stocks. But when I look at its last report I find reasons for short-term concern. Revenues declined eight percent y/o/y (year over year) and operating income was down 16 percent.

Amazon (NASDAQ:AMZN), with a market cap of $406 billion and trading at a P/E of 173.9, was another company that missed expectation but has hardly missed a beat as its stock price is near its record high. The company reported revenue that missed consensus expectation by $1 billion.

Microsoft (NASDAQ:MSFT) has a market cap of $501.4 billion and P/E of 30.5 but is barely growing with revenues up just 1.2 percent y/o/y with EPS not doing much better. Does this really justify the P/E and a stock trading a hair's breadth from its record high?

Alphabet/Google (NASDAQ:GOOGL) / (market cap $595.6 billion; P/E 31.29) missed earnings expectations by $0.31 per share. That was its second big miss of the past year. But does it matter? No, of course not. When every an investor buys more shares of the leading index ETFs they also indirectly buy more shares of all of these stocks.

And then there is Tesla (NASDAQ:TSLA) which may not be one of the leading large cap stocks but is definitely a darling of Wall Street. I am not saying that it is all gloom and doom in the future for TSLA, it is just that the stock price seems to defy gravity in instances that would prompt concern with other companies. I have read comparisons of TSLA to Ford (NYSE:F) in terms of market cap, profitability, revenue, etc. I will not dive into those numbers because it really is not a fair comparison. If TSLA can master its production and sales over the next three years the price may be justified. However, it appears that it will need a lot more cash infused into the company during that time.

The company raised $1.4 billion in Q4 of 2016 and has burned through much of that already ($450 million for operations and ~$600 million on capital expenditures). Tesla is expecting capital expenditures of $2.5 billion in the first half of 2017. That means more dilution of existing shareholders. For most companies that would be a huge problem. Apparently, where Tesla is concerned, that does not matter.

For an analyst who strongly favors fundamental analysis all of the above instances (and many more) give me the feeling that investors are being irrational again. Speaking of irrational investors, we should take a look at sentiment.

Investor Sentiment is in the Irrational Exuberance Zone

The first chart is from Meridian Macro Research displaying personal consumption expenditures (minus services). It does not paint a very optimistic picture.

The last time this chart looked this ominous was in 2008.

My next chart is from the University of Michigan on Consumer Sentiment. This looks very different from the above chart but look at the pattern compared to previous years.

We have not seen this level since 2007. The same contrast between the two indicators was evident before the last recession and market crash. That time we had the subprime bubble making everyone feel invincible and wealthy. We will worry about what to name this one after we figure out what causes it to burst. That is usually how it works.

Now, we need to look at one more chart, this one is from and provides some more evidence of exuberance, record levels of margin debt.

Notice that in the last two instances (2000 and 2007) when margin debt rose to near $400 billion it marked a market peak and occurred only months before the economy fell into recession. This time it is different! Margin debt is now over $500 billion for the first time in recorded history (other than 2015). Investors are leveraged to an extreme and more exposed to risk than ever before. I cannot help but think that we will be able to look back at this period in time and see how obvious this should have been.

Another chart to ponder is this one from Meridian Macro Research that illustrates how weak the wholesale sales have been relative to wholesale inventories.

Notice once again that the last time things appeared this weak was late in 2008.

Now the final two charts, courtesy of the St. Louis Federal Reserve branch and the Atlanta Fed, shows us the velocity of M2 money supply is still falling and the latest forecast for GDP is showing signs of stagnation in economic growth.

If the economy were as strong as is indicated by record stock market valuations this indicator would be at least trending flat or more probably turning upward. This is usually an indication of more slow growth ahead, something that should not (except in a bubble) support a rising stock market.

And finally, we need to look at how fast the economy is growing in the current quarter. Certainly it should be expanding at a rate over two percent. But no, the latest forecast by the Atlanta Fed is for growth in GDP of 0.9 percent, only half the rate of the dismal fourth quarter of 2016 (1.8 percent).

These last two charts were added to provide more circumstantial evidence that investor sentiment is not in tune with actual data measuring economic activity. That appears to be what I consider irrational and exuberant since there does not seem to be much support for the emotional response in the real world.


I want to caution readers on one primary point. While there are many indicators that we are in a stock market bubble, in my opinion, there is no way of knowing how long this bubble can continue to inflate. Thus, I am not trying to indicate that investors should go out and sell all stocks to avoid an imminent crash. I have no clue as to how long the markets will continue higher and do not care. I am hedged against major loss and taking precautions to reduce my risk.

I buy put options to hedge against loss, hold only those stocks that I deem to be of high quality that will rebound quickly and are not overvalued based upon my own valuation metrics of DDM (dividend discount model) and free cash flow. I am also accumulating cash to be deployed when the next recession takes the markets back down to a more reasonable valuation. I am a patient, long-term investor who avoids adding risk when the market appears to be nearing another peak, which it seems to be today. I may be early but I would rather give up the last ten percent than risk losing 50 percent of my portfolio.

As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge. Don't forget to hit the "FOLLOW" button at the top of the article next to my name to keep up to date on my next moves and full accounting of results for the strategy.

For those who would like to learn more about my investment philosophy please consider reading How I Created My Own Portfolio Over a Lifetime.

Disclosure: I am/we are long AAPL.

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.

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