Regardless of last week’s slight tapering of the Federal Reserve’s policy of quantitative easing, speculators appear intent on completing the same bubble pattern that has attended a score of previous financial bubbles in equity markets, commodities, and other assets throughout history and across the globe.
The chart below provides some indication of our broader concerns here. The blue lines indicate the points of similarly overvalued, overbought, overbullish, rising-yield conditions across history (specific definitions and variants of this syndrome can be found in numerous prior weekly comments). Sentiment figures prior to the 1960’s are imputed based on the relationship between sentiment and the extent and volatility of prior market fluctuations, which largely drive that data. Most of the prior instances of this syndrome were not as extreme as at present (for example, valuations are now about 35% above the overvaluation threshold for other instances, overbought conditions are more extended here, and with 58% bulls and only 14% bears, current sentiment is also far more extreme than necessary). So we can certainly tighten up the criteria to exclude some of these instances, but it’s fair to say that present conditions are among the most extreme on record.
This chart also provides some indication of our more recent frustration, as even this variant of “overvalued, overbought, overbullish, rising-yield” conditions emerged as early as February of this year and has appeared several times in the past year without event. My view remains that this does not likely reflect a permanent change in market dynamics – only a temporary deferral of what we can expect to be quite negative consequences for the market over the completion of this cycle.
Narrowing our focus to the present advance, what concerns us isn’t simply the parabolic advance featuring increasingly immediate impulses to buy every dip – which is how we characterize the psychology behind log-periodic bubbles (described by Didier Sornette in Why Markets Crash). It’s that this parabola is attended by so many additional and historically regular hallmarks of late-phase speculative advances. Aside from strenuously overvalued, overbought, overbullish, rising-yield conditions, speculators are using record amounts of borrowed money to speculate in equities, with NYSE margin debt now close to 2.5% of GDP. This is a level seen only twice in history, briefly at the 2000 and 2007 market peaks. Margin debt is now at an amount equal to 26% of all commercial and industrial loans in the U.S. banking system. Meanwhile, we are again hearing chatter that the Federal Reserve has placed a “put option” or a “floor” under the stock market. As I observed at the 2007 peak, before the market plunged 55%, “Speculators hoping for a ‘Bernanke put’ to save their assets are likely to discover – too late – that the strike price is way out of the money.”