Americans long ago came to the realization that Wall Street had detached itself from Main Street. That is, the stock market operates in a universe that’s completely distinct from the real world economic experience of most Americans. That detachment has been so accepted, that it?s virtually taken for granted. People continue pouring money into stocks, even if they aren?t sure why they?re going up. But we have perhaps the best evidence of a stock market bubble ? we?re in the any news is good news phase. No matter how bad the news is, the market keeps going up.
If the market has long since detached itself from Main Street, it?s now clear that it?s also completely detached from reality. No event that takes place anywhere in the world causes this market to fall by much more than 5% for very long. That’s a stock market bubble.
If you?re invested in this market, that may feel good. You may also have drank from the Kool-Aid that convinces you that this is the way it will always be. So it is with all investment bubbles. You know that the bubble-burst phase is near when the market ignores any bad news.
Any News is Good News ? The Stock Market Ignores Bad News
Below are six examples from the past 12 months where the market has ignored major, bad news. That isn?t to say that any of these events are catastrophic in and of themselves. But they do point to the real potential of instability. And at least traditionally, Wall Street has absolutely detested uncertainty. We can only assume that investors are completely ignoring the bad news.
Feel free to skip over this section if you?re in a hurry. I just included it to provide examples of how Wall Street has clearly moved into the any-news-is-good-news phase.
(S&P 500 market data from Yahoo! Finance.)
The S&P 500 opened on June 1, 2016, at 2093.94. The market moved sideways most of the month, closing at 2113.32 on the 23rd. On Friday, June 24, 2016, the result of the nationwide referendum that would decide on the British exit from the European Union was announced. Britain would leave.
Many analysts had argued that Brexit would be a disaster for the UK and for the financial markets. The market reacted by closing down 76 points, or about 3.5%, at 2037.41 later that day. The following Monday, the market continued down, closing at 2000.54. In two days, the index had lost about 113 points, or more than 5%.
But on Friday, July 1, just one week after the Brexit result was announced, the S&P 500 had fully recovered. It closed out the week at 2102.95, virtually returning to the level on the eve of the announcement of the Brexit results. By the end of July, the index closed at 2173.60, up 80 points, or about 4% for the month.
Brexit was meaningless to the market.
2. The Trump election
The Establishment had been clear in its position that a Donald Trump election ? as unlikely as it was to happen ? would be a disaster for civilization. But the market reaction to Trump?s ?surprise? victory: yawn.
The market opened the month at 2128.68. On November 9, the day after the election and when everyone knew Trump had won, it closed at 2163.26, up 35 points month-to-date. It closed out the month at 2198.81, up 70 points for the month. Today it stands at over 2400, seven months after the election ?disaster?.
Trump?s election, despite the disaster it was predicted to be, doesn?t hurt the market one bit.
3. North Korean nukes
It seems that every week we get treated to new revelations about the progress of the North Korean nuke program. Now war has never been a problem for Wall Street. In fact, the street loves a good war. The government takes decisive action, military spending goes up, the country forgets its domestic troubles for a season or two, and yet another victory is in the offing. What?s not to love?
In recent decades, America?s military actions have been swift and successful. We attack other countries or shoot down their aircraft with impunity. We?re invincible.
But nuclear war is a different animal entirely. If we do launch attacks against North Korea there?s more than a slight chance that they?ll respond with a nuclear strike. Countries don?t attack other countries that have nukes. The potential to sustain serious losses of personnel and equipment is too high.
No matter how many nukes North Korea tests or how many missiles they launch, Wall Street acts as if it will be just like the Gulf War: another ?good war?. We?ll thoroughly annihilate them, and take very few casualties in the process. The market has continued to advance over the years despite the increasing threat of nuclear weapons being in possession of a hostile power that probably isn?t afraid to use them.
Apparently the potential loss of a US aircraft carrier or two, or the flattening of Seoul or Tokyo doesn?t affect Wall Street either. But there’s no stock market bubble here, right?
4. The Manchester bombing
This one is so puzzling that it even caught the attention of The Street (Why Markets are Shrugging Off Manchester). Admittedly, terrorist actions have unfortunately become commonplace in recent decades. But in a real way the Manchester concert bombing represents an escalation. A terrorist specifically targeted an event that was attended primarily by kids.
Wall Street?s reaction? The market opened that Monday at 2387.21. By the close the following day, when the news had been fully digested, the market closed 2398.42, up 11 points in two days. By the end of May, the market closed at 2411.80.
It was business as usual in the financial markets.
5. The James Comey ?bombshell(s)?
Early in June we were treated to a ?bombshell testimony? by fired FBI Director James Comey. He disclosed, among other revelations, that President Donald Trump had pressured him to drop the investigation into possible collusion/interference with/by the Russians in the 2016 presidential election. Whether those allegations are true or not no longer seems to be the issue ? the main focus now seems to have shifted to obstruction of justice charges against Trump.
The word ?impeachment? is making the rounds, and seems to be the ultimate objective, regardless of the charge(s) du jour. Whether you support that outcome or not, political upheaval is never good for an economy or for the financial markets.
But in true stock market bubble form, the market is ignoring this potential eruption as well. Despite the media fanfare surrounding Comey?s testimony, the market is now just where it was at the beginning of June, in the low 2400s. In fact, the market showed no reaction to the hearings on the 8th, the 9th and the 12th, which were the days of the hearings, and the peak news flow from the media and talking heads.
This points to an interesting puzzle. Whether the market loves or hates Donald Trump doesn?t seem to matter. The market has risen successively since his election, but failed to crater when Comey?s testimony opened the prospect of Trump?s removal from office.
Does Wall Street love or hate Trump? It doesn?t seem to matter.
6. The James Hodgkinson shooting
Most recently (June 14), we?ve had the James Hodgkinson shooting. What distinguishes this attack is that Hodgkinson specifically targeted Republicans. That makes it a violent attack on a political party. Not just an individual, but an entire political party.
It?s not ridiculous to speculate that this lone shooting episode has the potential to trigger more and bigger problems going forward. The mood in the country is uncharacteristically tense, and even conducive to violence.
On June 13 the market closed at 2440.35. On Thursday, June 15 ? the day after the shooting ? the market closed at 2432.46. It lost all of 8 points in two days. In Wall Street terms, the shooting didn?t even create a ripple.
No problem here either, just keep moving along.
OK, enough examples. I could come up with more, but I think the point?s been made. Wall Street is immune to reality. At every episode of bad news, Wall Street responds with This doesn?t affect us.
Stock market bubble? You decide.
The Stock Market and Interest Rates
I?m of the opinion that interest rates are the primary driver of the stock market. Fixed income investments, like bonds and certificates of deposit, are in direct competition with stocks. If an investor can get a 10% return in CDs, he will be very reluctant to take a chance on stocks, since they also have the potential to lose money. But in a low interest rate environment, like the one we have, stocks become the investment of choice.
This isn?t a casual connection. The super bull market in stocks started in 1982. Back then, the Dow Jones Industrial Average hit a low of 777 for the year, in an environment where the rate of return on US 10 year Treasury notes was north of 14%. We?ve seen a steady decline in that rate for the past 35 years, that?s been paralleled by an equally dramatic rise in stock prices.
Today, the rate on the 10 year US Treasury note is just above 2%. Meanwhile, the Dow is sitting at over 21,000.
This helps to explain why stocks have performed so reliably since 1982. In fact, they?ve performed so reliably that we?ve had three bubbles during that time, each ending in a market crash (1987, 2000 ? 2002 and 2007 ? 2009). It?s no coincidence that each crash followed an increase in interest rates.
The interest rate picture is now changing
We?re now seeing a similar increase in interest rates, the first in nearly 9 years.
In response to the Financial Meltdown, the Federal Reserve lowered the Fed Funds rate down to nearly zero by the end of 2008. They left rates at that level for the next seven years, despite allegations of an improved economy. It?s easy to see why the stock market went on an elevator ride up during those years.
But beginning in December 2015, the Fed began reversing the trend. That month they increased the Fed Funds rate by a quarter point. Subsequent quarter point increases followed in December, 2016, and March 16 and June 15 of this year.
On December 16, 2015, the day before the first rate hike, the market closed at 2073.07 on the S&P 500. And despite four rate hikes adding a full point to the Fed Funds rate in that time, the market is now in record territory at over 2400.
It would appear, at least up to this point, the stock market has also decoupled itself from interest rates. Since it long ago split off from the Main Street economy, this is hardly a surprise. But if the Fed is serious about raising interest rates further, reality will have to assert itself. When a market detaches itself from one of its fundamental drivers, that’s one of the very best reasons to believe that we’re in a full-blown stock market bubble.
For the time being however, it appears that something else is happening.
What?s Really Driving the Stock Market Bubble?
Here?s the best explanation I?ve seen: The ETF phenomenon.
A report that appeared on Bloomberg in January reported that stocks have been replaced by ETFs as the most actively traded securities on the financial markets. The article reports that 12 of the 15 most traded securities in 2016 were exchange traded funds (ETFs). Only three were individual stocks.
This represents a fundamental shift in the very way the stock market works. ETFs are typically tied to various sector indices, such as the S&P 500 or the Russell 2000. They are, by definition, passive investment vehicles. The funds don?t actively trade stocks, but do so only when there is a change in the composition of the underlying index. People invest in ETFs instead of individual stocks.
The article reports that there are now more than 2,000 ETFs. By contrast, there are only about 3,600 individual stocks trading on the markets, which is down more than 50% from the 7,500+ that existed as recently as 1998. That means that now there aren?t even enough stocks to fill the Wilshire 5000!
It?s even not inconceivable that at some point there will be more ETF?s than there are individual stocks available to fill them. That?s exactly where the trend is heading.
This is a significant departure from traditional stock market investing
The investor no longer concerns herself with the merits of individual stocks. Instead, she turns her money over to the ETF. The ETF?s only concern is with maintaining a portfolio composition that matches the underlying index. It matters not if the stocks they?re filling their portfolios with are legitimately good, complete disasters, or something in between. The entire process is mechanical, not qualitative.
As people pour money into index funds, typically through retirement plans, the money chasing stocks via ETFs expands. This pushes stock prices higher, regardless of underlying fundmentals.
This represents pure speculation. It would be if as if two investors were to repeatedly buy and sell the same house to one another, but each time for more money. While the house is originally traded for $100,000, it?s eventually bid up to $1 million. The investors feel richer as a result, but the intrinsic value of the house is the same as it was on the first sale. The increase is strictly a function of price, not real value.
So to put this outcome in its simplest perspective, stocks are rising primarily because there is more money chasing after them through ETFs. The actual investment value of the stocks themselves is immaterial.
This helps to explain why the market is trading at 24 times earning versus its historic average in the 10 to 14 range. In fact, it?s now at a level that?s consistent with where it was before the crashes of 2000 and 2007.
Do you still think there’s no stock market bubble?
Where This is Likely to Go, and How it Will Effect Your Investments
If you?re big into the stock market right now, this all reads like doom and gloom. But it should also be a legitimate warning. The most recent iteration of the super bull market that began in 1982 has been running virtually unabated since 2009.
I believe we?re very close to a turning point. The market has been ignoring the real economy for years. It?s now in the any-news-is-good-news phase, where it?s ignoring disturbing events. But perhaps more importantly, it?s even ignoring the rise in interest rates.
Given that low interest rates are like a magic tonic to stocks, ignoring rate hikes qualifies as collective insanity. It also confirms that we?re in a stock market bubble.
When will this one pop? It?s anyone?s guess. I have no inside knowledge myself. But the signs are everywhere. And from what we know to be a fact based on history, this market will ultimately go the way of all investment bubbles that have gone before it. That means it will end, despite the current euphoria.
A Reasonable Investment Strategy for a Stock Market Bubble
If you?ve done well in stocks over the past few years, this is probably an outstanding time to start taking some profits. In another year or two, you don?t want to be standing shoulder-to-shoulder with the financially wounded masses, who will be looking back at this market saying what the Hell were we thinking?, and why did I wait so long to get out?
That doesn?t mean abandoning stocks completely. But if you have 80%, 90% or (gasp) 100% of your money invested in stocks, you should pare that back. A 50% position or less will enable you to participate in future increases, while also protecting a big chunk of your money from the carnage.
And for what it?s worth, this isn?t a doom-and-gloom prediction either. The bust side of this stock market bubble will set up the next boom. And if you cut back on your stock holdings now, you?ll be preparing your investments to get in at the bottom of that next boom. But if you ?hold through the crash?, you might not have any money left to jump into that next elevator. You may even be too shell-shocked to try.
There?s an old saying, little pigs become fat pigs, and fat pigs get slaughtered. That?s what happens on the back end of virtually every investment bubble in history. But drunk on the moment, people ignore history, and get slaughtered. You can choose to not be a victim on this go-round.
What do you think? Rising stock market forever, or a day of reckoning coming soon? And if it’s the latter, what are you doing to prepare?