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When Might The Current Equities Bubble Bust?

Since the announcement of the Obama-Republican cut-tax-and-spend deal (win-win but fiscal responsibility be damned), equities have gone straight up and bonds straight down. If you don't watch the real economy, you'd think the recovery is real and well underway. By many measures, equities valuations are at extreme levels. This has some analysts and bloggers crying bubble.

I agree it's bubbly. But I'm not sure the bust is imminent.

High valuation alone is not enough to bust a bubble. There's a reason, valid or not, behind the high valuation. Unless and until that premises is invalidated, the high valuation may keep going higher. The current premises is expectation that the cut-tax-and-spend deal will be passed and will succeed in stimulating the economy, finally. So the current bubble will go bust when that premises begins to appear shaky, but probably not before. What kind of events could shake the recovery expectation?

1. Congress doesn't pass the cut-tax-and-spend bill, or significantly scales it down. But the voters love it so much, who cares about the tax-payers? Screw'em, like we voters always do to them damn tax-payers.

2. International factor, China. If China had raised rates last weekend, it might have triggered a broad sell-off, judging by recent (over-)emphasis on Chinese economy. But interestingly, the market has shown little enthusiasm to the lack of rate hike. So conversely, China factor is unlikely to bust it, at least unless it's more substantial and concrete than a rate hike.

3. International factor, Europe. I don't believe Euro contagion is an imminent risk until Spain is finally exposed. When would this happen? Back in June if you ask me but my last name is not Market. But I highly doubt the can can be kicked down the road beyond 2011 as Spain's funding needs spike in 2012.

4. Domestic factors. This could kick in any day, but I think it's unlikely soon. The more likely scenario is bad or not-so-good economic news keeps drizzling, after half a year or so when hopium alone finally cannot hold up the tarp over Mr. Market's head any longer.

Could the recovery turn real? In the short term (up to a few months), yes, it could, as corporate profit and luxury consumption continue surging and such effects will no doubt be mistaken as reinforcing the recovery case. Over a year or two, unlikely, since there's no way the cut-tax-and-spend deal, even coupled with QEn, could prop up housing and employment so soon -- if not damaging them (see "rising mortgage rates"), which would be poetic irony. Over five to ten years, voters will finally realize they are the tax-payers they've been screwing. No, it won't the end of the world, just much much MUCH more pain than it would be if we did the right thing, which would be to learn the lesson and implement needed structural reforms and eliminate TBTF as we did to monopoly back in the day. Let companies fail. Let Mr. Market drop. It's ok. Don't let people scare you into a pussy supporting big government. Have some faith in free market.

Back to trading. I wouldn't be long or short equities except some especially high risk-reward cases, e.g., short NFLX (the momentum, it's gone, man), unless you day-trade. You know I'm bullish on gold and I'll let you know when I think it's time to cash out, even if temporarily, but today is not it. But more interestingly, based on the same arguments above, I think the bond sell-off is overdone. I wouldn't buy treasuries, munis, or junks; their upside are just too low for my greed (or risks too high for my fear, or both). But I think there're finally some value in high-grade corporates, e.g., some GECC, IBM, Pharmacia (Pfizer) bonds maturing in 2023-2027 yielding 5%+. Depending on your trading style, it may make sense to park some money in bonds, as reserve capital, even if you believe in hyper-inflation. For example, if you're an aggressive risk taker trading your own money, you could risk 100% loss on your trading capital for 10x gains if, and only if, you park the vast majority of capital in these or near-cash.