Since 1990, investors have experienced two bubbles, the tech bubble of 1999 and the real estate bubble of 2007. In both cases, investors believed there was a new paradigm. In 1999 investors believed one should be very overweight tech and telecom because the internet was going to be the way of the future. In 2007, you would be thought silly if you didn't believe that real estate was going straight up. Both times the stock markets crashed. Both times the Fed came to the rescue.
The first time the Fed lowered interest rates on the short end, making variable rate and teaser rate loans extremely attractive. Human nature to exploit this phenomenon led to massive issuance of variable rate debt and the conditions that led to massive subprime lending. The second time the Fed continued to lower rates to almost zero, began buying securities, and then doing the "twist." As can be seen on the chart below, the second Fed actions were more effective than the first.
I know that the chart is very busy, but here is a simplified legend.
N- New Paradigm
R- Feeling a return to normal
DN - Denial
C - Capitulation
The first bubble was a classic bubble caused by irrational exuberance. The second bubble was the unintended consequence of Fed actions to stop the capitulation of the markets and restore order. The third bubble … well I don't see one in the charts. Do you? What I think I see is probably the largest delusional rally in recent history. The first two phases were caused by QE1, QE2 and Operation Twist. It looks like a series of delusional rallies followed by denial corrections. This may be what a "wall of worry" looks like. What I do not see is any base building to give investors any confidence. Sure the stock market is almost at new highs and might even go to new highs. But the ups and downs since 2009 will not attract long term investors. Nor will this high volatility draw in investment business. We live in a world of "risk-on, risk-off."
The big question is whether or not this new pattern can bring long-term investors into the stock market? Probably not. That means that as the market rises the number of players become fewer. It also means the up-down waves become smaller and smaller. I believe that we probably have a number of real sellers at the old market highs around 1500 on the S&P, which will likely be the most this rally can possibly deliver.
Let's look at the downside. As no bubble appears to have formed on the charts, a crash is not likely anytime soon. (I know you might say that long-term bonds are a bubble waiting to burst, but the stock charts don't indicate this idea). It is clear that the new delusional buyers have cost basis from S&P 500 at 700 all the way up to 1400 (1500 if the market tops there). As true sellers meet delusional sellers, the dilusionists will begin to start taking losses on the way down. Presumably most of the new dilusionists are traders and they will try to protect their principal. That will trigger stop-loss selling. Stop-loss selling brings the markets down further and a downward spiral begins. Where does the selling end.
Since the dilusionists are selling to dilusionists, the selling logically does not stop until the last stop-loss is triggered below S&P 750. That's when the Fed will likely announce QE3. Happy trading!
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: My stock holdings make up about 75% of total equity. MSFT, COT, FTE, SNY, NSRGY, OXY, TEVA WMT, CNP, DVN, EOG, XOM, FFBC, GILD, MRVL, NBIX, NTLS, PEP, UAL, ABT, AFL, AM, CELTF, CSCO, CVV, FKWL, GLRE, GSVC, INTC, LLL, LMOS, PBR, PG, FXP, DFJ. I have this portfolio hedged with about 25% of the portfolio in RYTPX.