This Is Not An 'Irrational Exuberance'

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by: Macrotheme Capital Management LLC

Summary

This is not a market based on fundamentals.

The market odds are set by central banks.

So, follow the central banks - not the fundamentals.

Bespoke's recent article reports a high "irrational exuberance" reading, based on the fact that investors are currently very optimistic about the stock market (NYSEARCA:SPY) return over the next 12 months, despite admitting that the market is overvalued. The reference to "irrational exuberance" is related to Greenspan's assessment of the dot.com bubble of mid-to-late 1990s.

Well, this is not a case of "irrational exuberance".

"Irrational exuberance" is a trade when an investors understands that the odds are not in his/her favor, yet the pay-off from winning the bet is extremely generous, and thus provides excitement, in addition to potential financial gains. The "excitement" part allows paying a slight premium over the risk-return trade-off, which some call irrational.

For example, a lottery ticket is an "irrational exuberance" bet, as well as a bet on the roulette table at the casino.

In late 1990's, the dot.coms were in-fact valued as lottery tickets, and the values were assigned using the "real option" models, not the present value of future earnings models, which is what in-fact Greenspan stated.

So, the expectation was that some of those dot.coms would make it big in the future, while many would fail. For example, investors who randomly bought Amazon (NASDAQ:AMZN) in mid 1990's got the big pay-off, see the chart below.

Was it rational to buy Amazon in 1998, and pay extremely high premuim for a company with no earnings? At the time, no, but it was a bet - just like a lottery ticket, and this specific bet paid-off. Tesla (NASDAQ:TSLA) could be an example of a "lottery ticket" stock in today's market.

So, is the broad stock market (NASDAQ:QQQ) (NYSEARCA:DIA) today "irrationally exuberance", given that all valuation metrics are pushing the historically high levels?

Most likely, not. First of all, what is the future pay-off from the bet that would give an investor some excitement to pay a premium price today? Nothing - there is no generous pay-off on the horizon today. Trump tax-cut? If it happens, this could be only a one-time modest boost. Infrastructure spending? Other?

So, what are investors exuberant about now, without having a generous pay-off on the horizon? They are not exuberant, but they still expect the price to increase, despite high valuations. Why?

Here it is - the bet is that the game is fixed, or the dice is loaded, so the odds of winning are greatly in their favor. Specifically, "The global markets all come down to central banks", which is the argument of Michael Hartnett, the chief investment strategist for Bank of America Merrill Lynch, who reports that global central banks bought $1 Trillion of securities so far this year alone - the highest in 10 years.

So, playing this rigged game has been actually rational - the central banks have been willing to do whatever necessary to inflate the financial markets - so that's the source of market overvaluation.

Thus, rather than defining the current sentiment as "irrationally exuberant", I would define it as "rationally speculative".

The only problem is that most investors don't understand the game being played today. The rigged game will eventually end, and the odds are going to change, as all bubbles eventually burst, just like the housing bubble, which was also a rigged game created by the Fed.

So, investors playing the "other game" of fundamentals will continue to expect some kind of pay-off, even the odds set the central banks turn against them. These investors will end up holding stocks during the eventual bubble crash.

Similarly, investors playing the game of fundamentals might miss the rest of the "speculative rally" towards the top, or even worse, stay short during the bubble upswing.

Key implication: markets could appear to be "irrationally exuberant" based on fundamentals, but still "rationally speculative" based on odds set by central bankers . So, follow the odds set by the central banks - we will continue to report on this, as the game changes.

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.