6 Things To Ponder This Weekend

Is there a bubble in the financial markets?  This is probably been the most written about issue over the past two weeks.  However, as I stated in "Too Much Bubble Talk:"

"That lack of "economic success" will likely mean that the Fed remains engaged in its ongoing QE programs for much longer than currently expected.  The real surprise in 2014 could very well be an increase in size and scope of the current quantitative easing programs if interest rates remain elevated, deflationary pressures continue to increase and economic growth stalls.  The injection of more liquidity could very well drive asset prices to the irrational extremes of a true market bubble.  However, if that occurs, the majority of market analysts and economists will not be talking about a "bubble" in asset prices but why "this time is truly different."

 

Are we currently witnessing a market bubble?  It is entirely possible, but if it is it will be the first market bubble in history to be seen in advance."

That viewpoint was confirmed during Janet Yellen's Senate confirmation hearings when she stated:

YELLEN SAYS ECONOMY, JOBS 'PERFORMING FAR SHORT' OF POTENTIAL

YELLEN: SUPPORTING RECOVERY IS PATH TOWARD MORE NORMAL POLICY

YELLEN SAYS FED DOESN'T SEE BUILDUP OF FINANCIAL RISKS

YELLEN SEES LIMITED EVIDENCE OF 'REACH FOR YIELD'

YELLEN SAYS FED LOOKS OUT FOR ANY POTENTIAL ASSET PRICE BUBBLES

YELLEN DOESN'T SEE 'MISALIGNMENTS' IN ASSET PRICES

Are the markets currently in a bubble or is Janet Yellen correct?  This week's edition of things to ponder is a collection of views on this issue so that you can decide for yourself.

1)  This Is Your Brain In A Bull Market by John Coumarianos

"As for those metrics like PE10, our psychology invents all sorts of excuses to avoid them. For example, data before 1950 is sketchy, naysayers say, and the average since then is around 18, not 16.5. We’re coming off a terrible recession, and profits must continue to improve off the trough despite the fact that profit margins are at record highs, and show a powerful tendency toward mean reversion. Even typically sober observers like Jack Bogle argue that corporate profit growth will be 5% as far as the eye can see, which combined with a 2% dividend yield, will produce 7% annualized stock market returns or 5% adjusted for inflation. That’s not the historical 6.5%, but it’s not bad.

 

Another bullish argument: Prices were ridiculously low in 2009, so the runup until now doesn’t necessarily make them expensive. The counter for this argument is that PE10 bottomed at around 13 in early 2009. While below average, 13 is not ridiculously low.

 

So the problem is these may all be excuses and avoidances of a harsher reality. When prices rise like they have in recent years, the neurons in the primitive, reactive parts of our brains start firing, causing us, however perversely, to buy securities that cost more than double the price they did a few years ago. Higher prices are begetting still higher prices, not for economic reasons, but because of our psychological weaknesses."

2) Bull Today, Bear Tomorrow? by Paul Farrell

"Many optimists see this bull climbing up through 2014, like Merrill Lynch strategist Michael Hartnett and celebrity economist Nouriel Roubini. Some even see this bull roaring till 2017, repeating the incredible assault up the 2002-2008 mountain of worry. But not everyone’s optimistic lately.

Why? 2013 is a turning-point year. Some see today’s bullish columns as contrarian indicators when compared with earlier warning columns from Bill Gross, Gary Shilling, Peter Schiff, Jeffrey Gundlach and other bears. Remember, Gross’ warning that the bond market just ended a 30-year bull run on April 29? Then along came bulls like Hartnett and Roubini.

 

Now as we near year-end, a new twist. Bears are again growling: Hong Kong permabear Marc Faber and Nomura Securities’ strategist Bob Janjuah are reviving earlier crash warnings from the bears. And investors asking: Am I going crazy? Can I be both a bull and a bear? Bull today? Bear tomorrow?"

3) Citi Warns "Fed Is Kicking The Can Over The Edge Of A Cliff" via Zero Hedge

"It is becoming increasingly obvious that we are seeing the disconnect between financial markets and the real economy grow. It is also increasingly obvious (to Citi's FX Technicals team) that not only is QE not helping this dynamic, it is making things worse. It encourages misallocation of capital out of the real economy, it encourages poor risk management, it increases the danger of financial asset inflation/bubbles, and it emboldens fiscal irresponsibility etc.etc. If the Fed was prepared to draw a line under this experiment now rather than continuing to "kick the can down the road" it would not be painless but it would likely be less painful than what we might see later. Failure to do so will likely see us at the "end of the road" at some time in the future and the 'can' being "kicked over the edge of a cliff." Enough is enough. It is time to recognize reality. It is time to take monetary and fiscal responsibility - 'America is exhausted.....it is time.'"

4) Same Old Speculation In A New Guise by Comstock Partners

"The market continues to rise solely on the perception that the Fed's easy money policy can hold stock prices up indefinitely. We think that this line of thinking will prove to be no more durable than the dot-com bubble that peaked in early 2000 or the housing bubble that topped out in late 2007.  In both cases the market gave back a large proportion of the gains made during the bull market, and we believe that will prove to be the case this time as well.  When the vast majority of investors faithfully believe in a bubble, momentum takes over and the market goes up because it's going up, ignoring all of the obvious warnings such as high valuations, over bullishness, decreasing earnings momentum and an underperforming economy.  When reality suddenly sets in, as it inevitably does, most investors are left holding the bag, hoping that the market doesn't go any lower."

 5) 10 Laws Of Stock Market Bubblesby Doug Kass

To my five conditions mentioned earlier, I add five more (several of these quantify the "degree of bubbliness" to complete my 10 laws of bubbles:

1. Debt is cheap.
2. Debt is plentiful.
3. There is the egregious use of debt.
4. A new marginal (and sizeable) buyer of an asset class appears.
5. After a sustained advance in an asset class's price, the prior four factors lead to new-era thinking that cycles have been eradicated/eliminated and that a long boom in value lies ahead.
6. The distance of valuations from earnings is directly proportional to the degree of bubbliness.
7. The newer the valuation methodology in vogue the greater the degree of bubbliness.
8. Bad valuation methodologies drive out good valuation methodologies.
9. When everyone thinks central bankers, money managers, corporate managers, politicians or any other group are the smartest guys in the room, you are in a bubble.
10. Rapid growth of a new financial product that is not understood. (e.g., derivatives, what Warren Buffett termed "financial weapons of mass destruction").

6) Get Ready For The Mania Phaseby Richard Russell

"We spend our time searching for security and hate it when we get it." — John Steinbeck.

 

One of the basics of Dow Theory is the thesis of three psychological phases in both bull and bear markets. In a bull market, which we are now in, the first or initial phase is the early accumulation phase. This is the phase where wise and seasoned investors enter the market at or near the bottom, when many stocks are selling at great values after having been battered for months by the preceding bear market. Here many blue-chip stocks are selling "below known value."

 

The second phase of a bull market is usually the longest and most deceptive, containing many secondary reactions. During the second phase the retail public shows interest in stocks, and enters the market carefully and sporadically.

 

The third or speculative phase of a bull market is characterized by a wild and wooly and ever-increasing entrance by the retail public. This phase is characterized by hot tips, hype and pure greed."

Closing comment.

The third stage of bull markets, the mania phase, can last longer and go farther that logic would dictate.  However, the data suggests that the risk of a more meaningful reversion is rising.  However, it is necessary to note that "reversions" do not occur without a catalyst.  What will that catalyst be?  I have no idea and nor does anyone else.  Things that we are already aware of, like the upcoming debt ceiling debate, are already factored into the market.

It is unknown, unexpected and unanticipated events that strike the crucial blow that begins the market rout.  Unfortunately, due to the increased impact of high frequency and program trading, reversions are likely to occur faster than most can adequately respond to.  This is the danger that exists today.

Are we in the third phase of a bull market?  Most who read this article will say "no."  However, those were the utterances made at the peak of every previous bull market cycle.  The reality is that, as investors, we should consider the possibility, evaluate the risk and manage accordingly.