It has become popular to the point of redundancy to refer to any extended bull market as a “bubble.” 

The private equity trend?  That’s a “bubble” by the definition of the bubble experts.  

A hot sector that catches the interest of investors for any length of time will always be consigned to the bubble category by the financial scribes. 

Consumer credit is always relegated to the bubble category.  And a price spike in any commodity is sure to bring the bubble police to the scene.  

Even more perniciously, whenever stocks prices rise for any length of time you can be sure it will be protested every step of the way by those who scream, “It’s a bubble just waiting to pop!”

What has happened to investors today?  What transformation has influenced their thinking to the point where they no longer take advantage of what, in the old days, were called “trends” (as opposed to “bubbles”).  Instead of participating in a prolonged upside move to the benefit of their bottom lines, investors seem content to sit on the sidelines and hurl invectives at a market that left them behind long ago.

This sea change in retail investor psychology is easy enough to trace: it’s a delayed reaction to the Internet stock crash and bear market of 2000-2002.  

This once-a-generation event catalyzed a new attitude among investors that has tainted their outlook on the financial markets ever since.  This warped thinking has kept them from fully participating and reaping the fruits of the 2003-2007 recovery rally in stocks.  It has also sent them ducking for the bomb shelter every time the slightest hint of fear is felt in the financial markets.

To give you an idea of just how scared the average investor is of the stock market, take a look at the following chart.  

The above chart shows the trend since 2002 in stock market versus money market investments.  The public’s love affair with cash has been eclipsed only by its hatred of stocks.

One of the main reasons for the public’s reluctance to approach the stock market is the idea, falsely implanted by the financial press, that stock prices *could* be in a “bubble.”  Moreover, that bubble could burst at any minute.  

Investors were recently reminded in gruesome terms of the horror that occurred in October 1987.  There were myriad newspaper articles featuring a grisly flashback of Black Monday detailing how countless investors lost their shirts in the crash 20 years ago.  

No wonder then that the latest investor sentiment polls show the retail investor has once again gone into the bearish camp.  The bulls have all but evaporated in their fear of another October Massacre.  

Here are just some of the headlines from the Financial Times that have shown up in the past two weeks underscoring the widespread fear of bubbles:

“Bonanza for emerging market stirs bubble fears”

“Fears of bubble as Fed rate cut pushes equities to record high”

“Rush into green arena raises bubble fears”

“Bubbles leave a residue that can take years to shift”

“Concerns continue over credit bubble”

The problem with today’s fixation over bubbles in the financial markets is that our understanding has been skewed by the terrible experience of 2000-2002.  As touched on earlier, many investors had the harrowing experience of losing everything during the great “tech wreck” of those years.  This left a deep and abiding scar in their minds, one that even today is sore to the touch.

The 2000-2002 bear market/recession and more recently the housing market downturn, have led to an endless tirade in the popular press against bubbles.  Everywhere you turn, you’re barraged with bubble talk.  

Yet the term “bubble” is actually a misnomer.  There’s a better word to describe what happens when an asset becomes severely overpriced in relation to underlying value.  We’ll see what that is in a minute. 

Before we can discuss any issue intelligently we have to define our terms.  This is something that’s rarely done in public debate these days.  So let’s define what exactly constitutes a “bubble.”  

Webster’s Dictionary defines a bubble as “something that lacks firmness, solidity, or reality.”  It is also defined as “a delusive scheme.”  Can this be applied in any way to the stock market?

It would be well beyond the scope of this article to offer a comprehensive and detailed discussion of each of these points.  Instead, let’s do a cursory examination of each one.

Does the stock market lack firmness?  Stocks are currently 36% undervalued according to the IBES Valuation Model.  Does that sound like a market sitting on a weak foundation?  

Some critics have suggested that this valuation is skewed by earnings and profit margins being above trend.  But as Mark Dodson pointed out, “if forward earnings on the S&P 500 fell back to their long term trend (currently around $88), the stock market would still be more than 20% undervalued.”

He continues, “If forward earnings fell off an unprecedented cliff going as far under trend as they have since we have data (this last happened in February 2003 near the bottom of the three year bear market), the stock market would be approximately 5% undervalued. 

“Current valuations have the ability to absorb some unprecedented shocks to earnings,” he concludes.

What about the possibility that the bull market in stocks is a “delusive scheme”?  If there is any truth to this then it’s because investors see no hope for the future of companies in the U.S. If so, why?

After giving it some thought, I think you’ll agree that for someone to have a long-term bearish bias on the stock market is tantamount to saying that one doesn't believe in the power of human productivity. In other words, they are bearish on the productive capacity of Americans in the aggregate. 

Yet Americans have shown themselves to be the most productive, innovative and industrious workers in the world for well over 100 years. Why would anyone want to “short” that track record?

When investors get bearish on stocks, long-term, they are also saying they don’t believe in the power of technology to increase productivity and the aggregate demand for goods and services. What could be more misguided than to assume technology’s demise? If anything, the surface has only been scratched here and there’s a lot more potential for future discovery and application in this realm than most of us realize.

A perma-bear asserts the following credo (in the negative): “I don’t believe in human productivity or ingenuity, nor do I believe in the power of technology to expand economic performance, nor do I believe that the basic pursuit of the profit motive will benefit business corporations to any substantial degree in the long term.”

This sentiment contradicts the great principle of free enterprise upon which this country was founded.  Our ancestors would blush if they could read our financial press today, laced as it is with bubble talk.

“Bubble” isn’t the best word to describe today’s stock market.  A bubble is a thin veneer held together temporarily by nothing more than air.  There is no grounding or foundation for a bubble.  

There can be bubbles in the financial markets when the basis behind the increase in an asset’s price is non-existent.  For instance, the rapid inflation of the stock price of a shell company that doesn’t even exist is a bubble in the truest sense.  We saw this more than a few times during the late ‘90s Internet stock boom.  In such cases, when the inevitable collapse of the company’s stock price comes it can be likened to a bubble bursting since there was nothing behind it in the first place.  Moreover, a bubble that has burst can never be re-inflated.

What about the stock price of a company that makes essential products or services?  Can there ever truly be a “bubble” in the equity price of such a firm?  

Let’s take IBM as an example.  This famous company has been around for nearly 100 years and is the largest information technology employer in the world with more than 350,000 employees.  It also holds more patents than any other U.S. based technology company, according to Wikipedia, and is one of the most established companies in the world. 

Could there ever truly be a “bubble” in the stock price of IBM?  No, there couldn’t.  While there may be periods when IBM’s stock price exceeds the company’s true value, there’s no denying that IBM’s stock has, in opposition to Webster’s bubble definition, “firmness, solidity, and reality.”

A better term to describe an asset price that has temporarily expanded beyond the bounds of normalcy would be “balloon.”  Unlike a bubble, a balloon has greater elasticity and can expand to many times its original size without imploding…provided its construction is strong enough and its rate of inflation/deflation is done at a controlled pace.  So there could theoretically be a balloon in IBM’s stock price but this isn’t the same as a bubble.

Can there ever be a bubble in the truest sense of the word in the broad market for major stocks and commodities?  No, because there will always be a baseline demand for them regardless of the vagaries of investor sentiment and despite the occasional manias that may develop.  

Once a bubble bursts it never comes back!  A balloon can be rapidly deflated and stay deflated for a long time before eventually being re-inflated.  Therein lies the distinction.

Natural Resources

The XAU gold/silver index closed nearly 3% higher on Friday, Oct. 26, to end the week at a new all-time high of 182.41.  The Amex Gold Bugs Index (HUI) closed at 420.59 for a gain of 2.79% on Friday.

The CBOE Gold Index (GOX) call/put open interest ratio is still showing more call buying than put buying among the traditionally “smart money.”  The GOX call/put ratio has been the key to the PM stock sector rally from its beginnings in August.  It still hasn’t turned bearish yet as Friday’s (Oct. 26) reading of 0.22 shows a net bullish stance among the smart money traders.  This shows that market psychology is still skewed in favor of the bullish trend for the PM stocks.  

The leading silver stocks have recently been catching up to the leading gold stocks on the upside.  Of the actively traded silvers that have yet to breakout above key interim resistance, Apex Silver (SIL) and Coeur d’Alene (CDE) look like they could do so before the latest sector momentum fades.  Right now it’s  the 60-day internal momentum that is feeding the gold and silver stocks in their current rally phase.

The Amex Oil Index (XOI) closed at a new high level of 1,506 on Friday while the Natural Gas Index (XNG) also made a new high by closing at 560.50.  As I pointed out in last week’s commentary, there are some bullish patterns still visible in the charts of the leading oil and gas sector stocks.  

It was asked last week, “Could the oils be gearing up to play ‘catch up’ to the natural gas stocks?”  The answer to that question was a decisive “yes” based on the negative investor sentiment that was showing up, including the front cover of the October Futures magazine.  

This cover (which was shown in last week’s commentary) depicted a fearsome looking bear and the headlined asked, “Is the bear looming over energy markets?”  From a contrarian standpoint that’s all we needed to see to know that oil/gas stocks had more upside.  The crude oil price closed Oct. 26 at an all-time high of $91.86.

© 2007 Clif Droke
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Clif Droke
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