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Is There an Equity Bubble Developing?

Tue, Feb 21, 2012 - 12:00am

It certainly would appear as though the Federal Reserve is getting exactly what they want, higher equity prices. Could the current monetary policies of “extreme” asset purchasing by the Fed be creating a bubble type atmosphere in equities? I think so! Could we be heading for some turbulence in the very near future after some shot-term attempt to push the averages higher on some Greek deal? ABSOLUTELY YES! All I can say is be extremely careful in this over-extended stock market enviroment.

The bull case says “NO” while the bear case says “YES.” Let’s look a little closer.

Bull Case

  • Economy - an economic recovery is underway if one looks at the latest economic data points; EU is not dragging us down nor will they
  • Treasury Yields - no yield in treasuries equates to stocks must be bought
  • Multiple Expansion - stocks are being looked at as undervalued since there is no available returns anywhere else
  • Earnings - S&P 500 earnings projection are in the $100-$105 range; 1500+ can be attained based on a historic 15.8 X price-to-earnings ratio
  • Presidential Year - stocks typically move higher
  • Easy Monetary Policy - classic don’t fight the Fed which has not always proven to work; noted later in my Final Thought (bottom of editorial)

These are just a few of the noteworthy reasons I hear from the bulls to support their bullish argument.

Bear Case

  • Low volume - NYSE 4 week average volume at lowest levels since 1999, indicates no real conviction to upside
  • Negative Internals - appears as though we are having less and less participation pushing the averages higher
  • Non Confirmation - latest push to new highs in SPX were not confirmed by Dow Transports
  • 10 Year Treasury Note - yield hanging around +/- 2% suggests the bond market does not believe the advance in stocks
  • Short-interest-ratio - extreme low levels; has increased slightly of late (rumor has it some smart money is leaning back on the short side)
  • Market Sentiment - the bullishness is running rampant as the averages move higher; a sign of Euphoria and a warning sign
  • Multiple contraction - this certainly is something to be aware of if one presumes growth rates comparable to the 1950’s-1960’s
  • Earnings - they are not materially better as Bulls would indicate; not supportive of higher equity prices
  • Warren Buffet Indicator - he has been cutting his holdings back; usually tends to be early to the buy or sell side; interesting development to take notice of though
  • EU strains on US economy - regardless of a resolution or attempt at one, it all points to slow growth and austerity in the EU; this WILL have a negative effect on our economy
  • Barrons, DJIA 15K by end of 2013 - often times a contrarian indicator when a major market publication talks like this

These are a few of the noteworthy reasons I hear from the bears to support their bearish argument.

My Opinion:

The bulls and bears both might be correct; stocks might move higher in an eventual 5th wave blow off sometime this year based on the monthly chart wave count and then come crashing down. Let’s say this, at a bare minimum the stock market should see solid corrective action this year; 10%-15%.

I could envision this playing out in the short-term where we try and extend a bit further, see some corrective action (how much depends on events) and then see a potential 5th wave blow off higher in the spring time-frame.

Currently, the weekly charts are overbought while the monthly is not quite there yet and does not have to be for the market to roll-over.

Monthly Chart of SPX

Bulls are focused on this long term monthly chart with higher price targets in mind, SPX 1425-1450. As noted in my commentary above, you can see how a further extension of this market could come in a 5th wave move higher. Either way, a solid correction of 10-15% should occur this year.

If I am being really honest, I hate to say it, what you really have taking place is a variation of a market “Ponzi” scheme. It would appear as though institutions are continuing to buy and jam money into the “WHAT WORKS” stocks without any real justification such as rising revenues and earnings. What I am saying is, institutions are being forced to view and value stocks differently these days because nothing else is returning much yield thus justifying their argument for higher levels. I find it to be a very hollow argument since there is no real historical data and evidence to simply support higher stock prices nor sustain them without rising revenues and earnings.

Federal Reserve

Lastly, let’s not forget the Fed is walking an extremely tight line in regards to monetary policy.

  • Will the Fed conduct QE 3 if we see economic data slide?
  • Is the Fed behind the curve?
  • Do they really know the economy is getting better but talk it down to keep long-term rates (something they do not control) low for the next 1+ year to be able to refinance our debt at longer maturities?
  • If rates rise, does this create competition for stocks?

One can ask a lot more questions of the Fed but either way we are left without too many answers and a very dangerous situation.

Final Thought

Absent real meaningful growth in the economy that plays catch up to equity prices which I do not perceive occurring; I think one should heed the warnings and not forget the Fed induced equity bubbles we saw in 1999-2000 and 2007-2008. I cannot foresee a perpetual move higher in stocks without solid corrective action; 10%-15%.

This “Ponzi” scheme will only work for so long and when it stops, look out below.

Since December of 2008, we have been teaching our members in our nightly video updates and daily live webcasts to be vigilant in this continued complex market environment. We teach our members how to protect their portfolios and actually capitalize and make money in both rising and declining markets. Take advantage of our 1 week “FREE” trial and learn how we make money on our day trades, swing trades and investments, on a consistent basis.

About the Author

Senior Trader
BrianP [at] ProfessionalStockTraderLive [dot] com ()
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