5 warning signs of a stock market bubble
Comment of the Day

April 10 2014

Commentary by David Fuller

5 warning signs of a stock market bubble

Opinion: It turns out that the current sentiment is unlike that of March 2000

My thanks to a subscriber for this interesting article by Mark Hulbert, posted on Market Watch.  Here is the opening:

CHAPEL HILL, N.C. (MarketWatch) — The stock market slide in recent days, after the S&P 500’s 30%-plus surge last year, doesn’t represent the bursting of a bubble.

That’s crucial to consider, given the comparisons made by some pundits between the current market and that of March 2000, when tech stocks started evaporating.

Whatever else you might say about today’s stock market, it is nowhere near as overheated as it was 14 years ago. And that’s not a subjective view. My conclusion is derived from a data-driven focus on objective measures that were identified by the leading academic study of investor sentiment. That study, by Jeffrey Wurgler and Malcolm Baker, who are finance professors at New York University and Harvard Business School, respectively, was titled “Investor Sentiment in the Stock Market.”

The professors identified five indicators of investor sentiment that, over the past half century, were highly correlated with investors’ mood swings between the extremes of pessimism and exuberance.

Not surprisingly, the indicators showed a record level of investor optimism in March 2000. The picture they’re painting today is far different.

David Fuller's view

Here is Mark Hulber's full article posted on Market Watch.

The five indicators cited by Mark Hulbert are interesting and informative but do you agree with his conclusion?

I disagree to the extent that bubbles come in different sizes.  The 2000 bubble was massive and came at the end of the last secular bull market which commenced in 1982, in terms of valuation lows.  This bubble on Wall Street is considerably smaller but many fashionable shares soared to high valuations in 4Q 2013 and 1Q 2014, because they were not matched by earnings cash flow.  Instead, they were fuelled by easy money from the Federal Reserve and an increase in investor optimism.  Extremes of market sentiment are contrary indicators. 

So what happens next? 

I maintain that we have begun what will be a 10%+ correction for the S&P 500 Index (weekly & daily).  The bubblier Nasdaq Composite Index (weekly & daily) will see a bigger correction.  The Fed may try to check the decline, as we saw to a minor extent yesterday with its reassurance of lower interest rates.  That just sucked more people in who are underwater on those purchases today.    

Given the overdue 10%+ correction on Wall Street, uncertainties over Putin’s Russia and China’s economy, and the ongoing Fed tapering, I think we could easily see a bigger correction on deleveraging.  This graph of NYSE Margin Debt and the S&P 500, which I have shown previously, shows why. 

However, that would lower valuations and create another buying opportunity on Wall Street and other stock markets pulled lower by its influence.  Taking a somewhat longer-term view, short-term interest rates will stay low as central banks have already indicated, at least until reported inflationary pressures pick up.  That is unlikely to happen quickly because global GDP growth is slow, albeit gradually and somewhat erratically improving along with sentiment.

My guess is that we have a few moderate retrenchment years during which global GDP growth and interest rate policies normalise.  Thereafter, I think four factors will fuel the next secular bull market:

1. Lower energy prices in real terms due to increases in various supplies, from solar-led renewables to fracking for oil and gas, plus some new nuclear power.  

2. The accelerating rate of technological innovation which is dramatically increasing corporate efficiency among companies that are successfully adapting to these rapid breakthroughs. 

3. The increasing move towards global capitalism which has never occurred before.

4. The continued growth of middle classes, particularly in emerging markets.

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