| | | The stock market is in a FED created bubble right now and there are those who would deny it...
In fact, this bubble is more than 20 years old...
Most people will consider this assertion preposterous, but the facts don’t lie. Though the U.S. stock market has been experiencing a bubble for two decades, it will not last forever. I believe that the ultimate popping of this bubble will have terrifying consequences for both investors and the global economy that is tied so closely to the stock market.
The SP500 stock index has more than tripled since its low in 2009, but that doesn’t mean that we are out of the woods. On the contrary, this is the calm before the storm.
The incessant push to inflate our economy and financial markets has created an unprecedented situation in which stocks have been trading at overvalued levels for a record length of time. Nearly every stock market valuation indicator is giving the same reading: stocks are currently at levels that preceded other major historic busts.
Since the mid-1990s, the U.S. economy and stock market has experienced three different bubbles: the 1990s Dot-com bubble, the mid-2000s housing bubble, and now another bubble that includes stocks, bonds, tech startups, certain segments of the housing market, higher education, and much more. I believe that this new bubble is creating what I call a “Bubblecovery” or a bubble-driven temporary economic recovery that will end in another crisis.
The U.S. Federal Reserve also created a Bubblecovery in the early-2000s to recover from the Dot-com bust, which led to the housing bubble. After the housing bubble burst, the Fed inflated the post-2009 Bubblecovery. After each bubble/Bubblecovery ends, the Fed simply inflates another bubble to recover from the last one. In essence, the U.S. economy and stock market has been in a bubble cycle for the past two decades. Each time, the bubble gets larger, and the Fed has to keep re-inflating it to avoid the economic Depression that would occur if asset prices were allowed to find their true value.
For example, look at the Cyclically Adjusted P/E Ratio (CAPE), or the price-to-earnings ratio based on average inflation-adjusted earnings from the previous 10 years. The 1929 Stock Market Crash and 1970s stagnation occurred after the CAPE rose over 20 – a level that indicates stock market overvaluation. Incredibly, the CAPE has remained over 20 for much of the past two decades, aside from a few short months during the Global Financial Crisis. Without constant Fed intervention, there is no doubt that the U.S. stock market would have corrected violently like it has in the past.
While some stock market bulls dismiss the CAPE (likely because it doesn’t fit their “stocks are cheap!” narrative), here is another valuation measure giving the same reading. The Price-to-Peak Earnings Ratio, or the current price of the S&P 500 divided by the highest level of earnings achieved to-date, shows that U.S. stocks have been overvalued since the mid-1990s as well.
Tobin’s Q Ratio (the ratio of the market’s price to replacement costs) also shows that U.S. stocks have been overvalued for two decades:
The total market capitalization-to-GDP ratio, which Warren Buffett claimed is “probably the best single measure of where valuations stand at any given moment,” tells the same story:
Dividend yields – which move inversely with stock valuations – have also been at record lows since the mid-1990s. The mainstream narrative explaining this phenomenon is that companies now prefer to re-invest their earnings instead of pay dividends, but this explanation is fishy because dividend yields are giving the same exact reading as the other valuation indicators shown in this piece. There is likely some degree of truth to the mainstream explanation, but I believe that the market overvaluation thesis is the most convincing.
The key takeaway is that overvalued financial markets are not sustainable and must eventually experience a correction that returns them back to their fundamental value. In a free market (unlike what we have now), stock valuations move in waves, alternating from undervaluation to fair valuation to overvaluation, and back again. The Federal Reserve, by trying to keep the bubble constantly inflated, has distorted this natural process. Regardless, U.S. stocks will come back to earth when the Fed finally loses control of the situation, and the final comedown will be far more painful than would occur in a free market.
How has the Fed kept the stock market inflated for so long? One way is by steadily cutting its benchmark Fed Funds Rate to an all-time low and holding it there for an unprecedented length of time. Interest rates have been falling since the early-1980s, and their low levels in the past two decades have helped to buoy stock valuations. Low interest rates fuel asset bubbles because it makes saving (or holding cash) less attractive than investing in riskier assets like stocks that are rising at a rapid rate.
Record low interest rates have also encouraged speculators to borrow on margin to buy stocks, as they have during the last two bubbles, and before the 1929 Stock Market Crash. The heavy use of margin has helped to keep stock valuations inflated for the past two decades.
After the Financial Crisis, the Fed became increasingly desperate to re-inflate the bubble that was trying to fall on its own weight, so it took steps that it didn’t take during the late-1990s and mid-2000s bubbles: it resorted to outright money printing to pump liquidity into the economy and financial markets. As the chart below shows, the Fed created nearly $4 trillion worth of new money via its quantitative easing programs. Each QE injection led to a corresponding surge in stock prices.
Record low interest rates have dramatically reduced corporate borrowing costs, so large companies have been borrowing from the bond market and buying back their own stock, further inflating the two decade-old stock bubble. SP500 companies have bought back $2 trillion worth of their own stock since 2009 and $6.9 trillion in the past decade.
The Fed’s efforts to maintain the two decade-old stock bubble are working, and naïve investors are buying it hook, line, and sinker. The percentage of bearish investors (a contrarian indicator) has hit a multi-decade low of just 16 percent, which is far lower than during the Dot-com and housing bubbles.
HERE'S HOW THE STOCK BUBBLE WILL END...
The longer-term U.S. stock bubble will end when the very fuel behind it is removed, which is record low interest rates. There are two ways that rates will rise and pop the stock bubble:
Scenario #1: After several more years of the Bubblecovery or bubble-driven economic recovery, the Federal Reserve has a “Mission Accomplished” moment and eventually increases the Fed Funds rate too high, creating a hard landing that pops the post-2009 bubbles that were created by stimulative monetary conditions in the first place. Rising interest rates are what ended the 2003-2007 bubble, which led to the Global Financial Crisis.
Scenario #2: The ballooning and unsustainable amount of government and corporate bond market debt eventually causes investors to jettison bonds en masse, which leads to much higher interest rates.
For those who are not wary of this market, it will not end pretty...
forbes.com
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