Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Russell 2000: A Bubble Floating In A Needle Factory. Consider Buying RWM

|Includes: ProShares Short Russell2000 ETF (RWM)

Russell 2000: A Bubble Floating in a Needle Factory. Buy RWM.

I believe that we are in the midst of an equity bubble that is closer to the end than to the beginning. I would not be surprised if it broke soon. Here is the reasoning behind my view that a bubble exists, and why I think it is best to bet against it now:

Fundamentals underlying the equity markets are poor.

  • The global economy is in bad shape. Southern Europe is in a depression that will likely get worse (continued credit contraction, rising taxes, policy instability). Most of Northern Europe is in recession, and Germany may soon follow suit. Japan's economy is struggling from plunging exports. China is slowing. US GDP growth has been bumping along near 0% for a while now, with no good prospects for improvement. Indeed, we think there is a good chance that the US economy is now, or soon will be, contracting.
  • Earnings growth in the US is anemic. Ex-financials (which can pretty much make up their own EPS numbers), and ex-share buybacks (which should drive P/E multiples down), EPS growth is now zero or slightly negative. With profit margins rolling over from historically high levels and revenue growth flat/negative, where is earnings growth going to come from? Yes, that's a rhetorical question.

The global financial system is very fragile and under severe stress.

  • Europe is one policy mis-step, or even just one unforeseen event, away from severe dislocation such as a major bank run.
  • Japan's death spiral is accelerating and their new aggressive monetary policy could very well usher in the terminal phase.
  • China has a truly massive credit bubble. It could pop next month or it could last another 5 years, but when it pops there will be trouble.
  • In the US, capital continues to be misallocated due to relatively heavy central planning. And at some point, although perhaps not for a few more years, $1+ trillion deficits will become a problem.

And yet the market continues to ramp higher. Why?

  • Is it legitimate expectation of improved economic growth? Obviously, no.
  • Is it legitimate expectation of healthy earnings growth? Obviously, no.
  • Have systemic risks declined? Obviously, no.
  • Is fiscal policy now more conducive to growth? Obviously, no.
  • Are multiples at low, or even mediocre, levels? No. This may not be obvious, because on a forward operating earnings basis, relative to the past 15 years or so, the market looks reasonably valued. However, operating earnings are bogus. Firms take out the bad stuff and leave the good stuff in. And operating earnings are currently even more inflated than usual vs. GAAP earnings. And forward estimates are bogus. Historically, they have been quite unreliable, and are especially so at present (next 4 quarters' growth estimates are 2%, 2%, 8%, and then magically‚Ķ17%). Also, valuations over the past 15 years or so have been quite high relative to history. Using GAAP earnings, cyclically adjusting profit margins, and comparing to a much broader sweep of history, valuations are now actually very high.

I believe that the market has drifted inexorably higher because we are in the midst of a Fed-induced stock market bubble. People are buying because prices are going up, and prices are going up because people are buying.

Two things have caused this bubble, in our view. First, investors have been incentivized to move further out on the risk curve due to declining returns for historically 'safer' assets. Second, a belief has developed among market participants that the equity market is a rigged game and thus they should bet with the house for easy profits. The reasoning goes like this- the most powerful people in the world (the central bankers) are hell bent on pushing the market ever higher, so you'd be a fool to stay on the sidelines.

Now, the mere presence of a bubble doesn't necessarily mean one should go short. It could mean you should go long. But not in this case, I believe. I believe we are closer to the end of the bubble than the beginning. Here is why:

  • The 'moving further out on the risk curve' phase may be nearly done. Returns on everything from treasuries to high yield debt are already historically low. And prospective returns on equities, based upon cash flows or earnings, are already quite low. And even if you want to argue that at least stocks will return say 3% per annum more than corporate debt, remember equities are not a close substitute for fixed income instruments.
  • Furthermore, my analysis of market participants' attitudes and emotions suggest to us that the end of the bubble may be near. One of the primary things that moves markets is investors' changing their beliefs. In that regard, there are virtually no bears left to convert. [Except for preppers and gold bugs, and they are not open to conversion]. The extent of equity managers' bullish positioning is historically high- can you say herd mentality?
  • Greed is also very prevalent, e.g. note the huge levels of margin buying lately.
  • Investors are also placing too much weight on the recent past- investors buy every dip, with good results, and thus think they should buy the next dip.
  • There is also a lot of fear in the market. No, not fear of losing money, rather fear of missing out on a rally. Indeed there is a lot of career risk at present- missing an 'easy' money / no brainer trade like betting with the house in a rigged game could easily cost you your job as a portfolio manager.
  • Last but not least, the idea that the market can't go down while the Fed is supporting it has become ingrained into investors' minds to an astonishing degree. This is no longer in the realm of conventional wisdom- it now seems pathological. Indeed there is no longer any mental reflex to hearing a respected commentator on financial TV say something like 'of course if the Fed doesn't stop QE, the market will just go up forever'. It reminds me of a conversation I had with a lady in 2006. She was placing a bid on a house, and explained to me that 'you can never lose money on a house'.

Disclosure: I am long RWM.