Order, Chaos And Bubbles In The S&P 500

by: Ironman at Political Calculations

The S&P 500 had something of a volatile day on 5 April 2017, gapping up by 7.52 points to open higher than the previous day's close of 2,360.16, then going on to peak at the day's high of 2,378.36 around 10:23 AM EDT, after which it hovered within a 5-point wide range below that level until 2:00 PM.

And then, the Fed released the anxiously awaited copy of the minutes to their March 2017 meeting of its Federal Open Market Committee (FOMC) meeting. After that, U.S. stock prices began nosing over before diving by more than 27 points to hit the day's low value of 2,350.52 at 3:34 PM EDT, before bouncing around and closing the day at 2,352.95.

As for the catalyst for the sudden swing, ZeroHedge's Tyler Durden fingered the Fed:

It started off so well: the blistering ADP payrolls report, the highest in over two years (despite disappointing PMI and ISM reports), sent stocks soaring off the bat with the Dow jumping nearly 200 points higher, rising as high as 20,887, and the S&P knocking on the all time high 2,400 door again, and AMZN to new all time highs, and making some wonder if the reflation trade had returned.

It was not meant to be, because while it took the market some time to digest the Fed's minutes, the FOMC delivered one of its loudest warnings to date that it was focusing not so much on inflation or employment, but was seeking to deflate what even "some members" of the FOMC agree is a stock bubble, warning that stock prices are "quite high", and warning that its forecasts face "downside risks" if "financial markets were to experience a significant correction."

With a total swing of less than 1.2% from high to low value on the day, we would describe the market's volatility during the day as being consistent with what we would describe as a "typical" level of noise that might be seen in stock prices on a daily basis.

But that didn't stop the more excitable among the market's analysts from blaring the "stock market bubble alert" horn (much like More Or Less' Banana Siren)! Here's a sampling of headlines featured on ZeroHedge from various contributors:

  • What Could Possibly Go Wrong? - Why This Time Is Not Different (Click here)
  • FOMC Admits The Stock Market Is A Bubble, Along With Many Other Asset Classes (Click here)
  • Stocks Tumble: Fed Spooks Traders With Bubble Warning (Click here)

It wouldn't be on ZeroHedge if it weren't both gloomy and doomy. In all honesty, however, all these analysts are mostly guilty of is overdramatizing the more neutral comments of the Fed officials, who never-the-less have clearly flagged high equity prices as being among their concerns for the future.

In their discussion of recent developments in financial markets, participants noted that financial conditions remained accommodative despite the rise in longer-term interest rates in recent months and continued to support the expansion of economic activity. Many participants discussed the implications of the rise in equity prices over the past few months, with several of them citing it as contributing to an easing of financial conditions. A few participants attributed the recent equity price appreciation to expectations for corporate tax cuts or to increased risk tolerance among investors rather than to expectations of stronger economic growth. Some participants viewed equity prices as quite high relative to standard valuation measures. It was observed that prices of other risk assets, such as emerging market stocks, high yield corporate bonds, and commercial real estate, had also risen significantly in recent months. In contrast, prices of farmland reportedly had edged lower, in part because low commodity prices continued to weigh on farm income. Still, farmland valuations were said to remain quite high as gauged by standard benchmarks such as rent-to-price ratios.

Now that have specified this concern, let's do a quick review of the S&P 500's recent history of both order and chaos in the U.S. stock market, where we can identify exactly where the bubbles driving the excitable market analysts so mad have really occurred:

By our definition, a bubble can be said to exist whenever the price of an asset that may be freely exchanged in a well-established market first soars and then plummets over a sustained period of time at rates that are decoupled from the rate of growth of the income that might be realized from owning or holding the asset in question.

Applied to stock prices, a bubble may be said to exist when the price of stocks changes at a rate that is not coupled with the growth rate of dividends, the payments investors might receive from holding stocks. And for what it's worth, over the last 26 years of stock market history, we can only find three instances where a bubble could reasonably be said to have existed:

  • The Dot-Com Bubble from April 1997 to June 2003.
  • The Fed-inflated QE 2.0 Bubble from August 2010 to August 2011.
  • The Apple Dividend Speculation Bubble from January 2012 to May 2012.

We're not even really confident of that last example, in that it only modestly disrupted the longer-term period of order in the S&P 500 in which it occurred, where we can argue that it doesn't pass the test for being sustained over a long enough period of time to qualify as a full-on bubble.

Still, when we review the current just over one-year-old trend for the S&P 500 as established from 31 March 2016 through the present against its underlying trailing year dividends per share, we can't say that we see anything like what we would even less-than-confidently call a bubble in the S&P 500's equity prices.

In terms of the relationship between stock prices and their dividends per share, we would say that the current trend is similar to, but not as strong as, the trend that ran from December 1991 to April 1997. It shows rapid stock price growth, but growth that is clearly coupled with the growth of dividends per share at the same time.

Keep in mind that we don't even need to have a bubble in stock prices for the market to crash, which should be plainly evident from what we can see in the chart above for the lead up to, and the aftermath of, the 2008 crash.

So if you're an overly excitable market analyst or a Fed official, just chill a bit before laying on talk of high valuations for stock prices as measured by price earnings ratios or other antiquated metrics as for why you personally believe stock prices are in a bubble. Chances are that all you're doing is clueing the public in on the direct evidence that you don't have a firm grasp of how stock prices work in the first place. And if you're a Fed official doing that in sharing your "knowledge" with overly excitable traders, just turn your belated resignation in now.