Warning Signs Continue to Proliferate

The stock market's advance becomes ever more suspect. Even though a 'blow-off rally' remains a strong possibility in view of continued monetary pumping, there are a number of factors that represent extremely strong warning signs and can usually only be observed in the late stages of a bull market.

There is for instance the narrowing of the rally to a handful of 'story stocks' that trade at ever more absurd valuations and seem to be able to inexorably rise into the stratosphere, discounting a glorious future that may or may not eventuate (stocks like AMZN, TSLA, NFLX, FB, CRM, YELP, LNKD, DDD, PCLN and so forth). In many cases valuations have become so stretched that even if one assumes that the most optimistic scenarios painted by some analysts and the buyers of these stocks actually do come true sometime in the next ten or twenty years, these stocks would still be overvalued.

Similarly, the pace of IPOs has vastly increased. Whereas IPOs were in 'slumber mode' for much of 2009-2012, issuance has really taken off this year and is at the highest level since 2007. Not only that, but many stocks are once again soaring by up to 100% on their first trading day, which is strongly reminiscent of the insanity that reigned in 1999 to early 2000.

Another facet reminiscent of both the 2000 and 2007 peaks is the huge amount of actual and announced stock buybacks (which are often financed by leveraging balance sheets). These buybacks help earnings per share to increase even as revenues stall, creating a Potemkin village of corporate profitability.

 

In numerous cases all that is achieved by buybacks is the lining of the pockets of managers, who receive stock options by the wagon load, leaving shareholders in no better position in the long term as the stocks issued in these incentive programs are destined to eventually hit the market. In fact, since corporate leverage is often increased in order to finance buybacks, shareholders in many cases will ultimately end up worse off. In the short term everybody loves the effects of buybacks of course, but be warned: they move in a pro-cyclical manner, which is to say buybacks tend to peak when stock prices are near a peak as well. After the 2008 crisis, many people realized that enormous amounts of capital had been wasted in the buybacks of 2006 and 2007. This has all been forgotten again, but we would argue that the same thing is true today that was true at the time: a lot of the current buybacks will eventually be revealed as an egregious waste of shareholder capital.

 

Margin Debt Soars to New Record High

However, if we had to pick out one feature of the Bernanke echo bubble that is most likely to eventually lead to huge losses for today's buyers, it is margin debt. As long as margin debt is rising, it helps the market to sustain its uptrend, as it represents a big source of buying power.

It becomes a bane though as soon as the market turns down, as it then produces forced selling and tends to exacerbate declines. According to this report at CNBC, NYSE margin debt has soared to a new record high, exceeding $400 billion for the first time ever.

 


 

Margin DebtNYSE margin debt vs. the S&P 500 index – click to enlarge.

 


 

As can be seen on the following long term chart of margin debt by sentimentrader, the negative net worth of investors was only greater in a single historical instance, namely during the peak months of the technology bubble in 2000.

In other words, the Fed has 'succeeded' to once again maneuver investors into a position that essentially guarantees that many of them will eventually suffer grievous losses. Note that in the event of a blow-off rally, the margin debt situation is likely to deteriorate even further.

For more charts illustrating margin debt and investor net worth, take a look at this page at Doug Short's 'Advisor Perspectives', which also includes charts that are inflation adjusted (i.e., adjusted by official consumer price indexes). What is slightly more easily discernible on Doug's chart page is that margin debt usually begins to decline a little bit just before the market embarks on a major downturn. This is valuable information that may prove helpful with timing the echo bubble's eventual demise. 

This also tells us that while we may well be witnessing the bubble's terminal stage, the end is probably not here just yet.

 


 

Margin debt, credit balancesNYSE margin debt, long term. Investor negative net worth has only been larger in the final stage of the tech bubble in 2000  – click to enlarge.

 


 

Along similar lines, Business Insider has recently 'discovered' what it thinks is an 'extremely obscure' indicator, namely implied Rydex money market fund assets. It may be obscure to BI, but it isn't to us. We always like to keep an eye on developments in Rydex funds, as this microcosm of market sentiment has often provided valuable information in the past. Below is a chart from decisionpoint that shows not only money market fund assets, but also the assets currently deployed in bullish and sector funds and those in bearish Rydex funds.

It is probably no exaggeration to state that bullish sentiment in terms of positioning remains 'off the charts' (as we have discussed on several previous occasions, this is also mirrored in the positioning of speculators in the financial futures markets).

 


 

Rydex assets

Assets in Rydex funds, via decisionpoint: Bullish and sector funds hold ten times more assets than bearish ones, money market fund assets are scraping the bottom of the barrel – click to enlarge.

 


 

The amount of assets held in Rydex money market funds is likely a reflection of how many investors expect a 'correction' and are therefore keeping some of their powder dry to buy the expected bargains once they appear. With these funds at the very low end of the historical range, it is reasonable to assume that very few people are thinking about the possibility that stock prices might actually decline anytime soon. Also, bears are obviously not especially confident either. While Rydex bear assets have been even lower earlier this year, the current levels certainly don't indicate a surfeit of bearishness, especially not when brought into context with bull assets that are near record highs (note that the the fact that both stock prices and bear assets are now higher than earlier this year constitutes actually a bearish divergence).

It is important to keep in mind however that the indicators discussed above are not really 'timing' indicators (with the exception we mentioned above, namely an initial decline in margin debt outstanding close to a peak in the market). One cannot look at these data and conclude 'the stock market will immediately decline'. That is not how it works. We have seen on a number of previous occasions – most notably in early 2000 – that the market can continue to soar in the short term even after such extremes are recorded and all these indicators can become even more stretched in the process. There are however several legitimate conclusions one can make:

 

1. the risk-reward situation in the market is dangerously skewed toward risk. Investors are skating on ever thinner ice.

2. once the risk becomes manifest, forced selling will exacerbate the decline in prices.

3. the more stretched these indicators become, the closer we get to a long term turning point.

 

Conclusion:

The stock market keeps levitating on the promise of more money printing. It remains possible that the advance will enter a 'blow-off stage' – a 'panic buying' type advance during which prices rise almost vertically, increasing considerably in a very short time. We keep mentioning this possibility because we know it has happened in the past when monetary conditions were very loose (admittedly, they have never been as loose as today, so in a sense the situation is actually quite unique).

However, keep also in mind that such a 'blow-off' doesn't have to happen. Whether or not it happens is in any case irrelevant to the assessment presented above: risk has increased enormously. Eventually, the market is likely to crash, leaving very little time for over-leveraged players to save their skins.

We leave you with one more chart that shows the latest divergence that has developed: while the SPX has made new highs, these have (so far, anyway) not been confirmed by the DJIA:

 


 

DJIA vs SPX,STThe latest divergence: DJIA vs. SPX (green line at the bottom of the chart) – click to enlarge.

 


 

 

Charts by: StockCharts, CNBC, Sentimentrader, Decisionpoint


 

 

 

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10 Responses to “The Stock Market Bubble’s Achilles Heel”

  • SavvyGuy:

    Easy money always creates bubbles in various markets, and oftentimes even in the same market after some time has passed since the last crash.

    After some initial disbelief from intellectually honest players, as evidenced by the market retracements in Summer 2010 and Fall 2011, market psychology has taken on a life of its own. Momentum players have jumped aboard, casting aside all fundamental and technical analysis, hoping to ride this market up to its very top.

    We have seen this movie several times before, and it does not end well. However, it is impossible to predict when the music will stop. But one otherwise fine day, stop it will.

  • rossmorguy:

    The article below contains several charts that show longterm divergences in the recent bull market. Because these divergences are of such long duration and, seemingly, technical importance, one would think that they indicate that more than just a “correction” can be expected, or that no mere correction will suffice to repair the damage that has already been done.

    http://www.financialsense.com/contributors/tim-wood/equities-big-picture

  • No6:

    I don’t think they will allow a crash. Any wobble will be met with more QE.
    (Voluntary abandonment of credit expansion was rejected in 2008)

  • rossmorguy:

    Thanks for another frightening (hardly) peek under the hood. With respect to the “divergence” between the (nominal) new high of the S&P and (nominal) so far lower high of the Dow, keep in mind that the Dow recently changed its membership, shedding some dogs for a few market favorites. So the Dow has failed in spite of cheating. But thanks to a shortage of obviously needed pipelines, thanks to the gumint, the Transports are more than holding up their end of the bargain. I gave up shorting this maket about 400 S&P points ago, or else I’d be in debtors prison today. By the time it all plays out though, I might’ve been better off just checking myself in, early.

    • jimmyjames:

      I gave up shorting this maket about 400 S&P points ago, or else I’d be in debtors prison today. By the time it all plays out though, I might’ve been better off just checking myself in, early.

      **********

      So many technical setups that all fizzled- because of sudden CNBC breathtaking news- I’m with you ross- a well bitten shorting ass-
      Goddamn the timing-
      5 or 10 times wrong and 1 right is an excellent trading ratio- provided minimum losses and maximum gains-
      I know you don’t need to be told this- but- don’t despair…

      Mr Market will have is say.. eventually-

  • rodney:

    It remains possible that the advance will enter a ‘blow-off stage’ – a ‘panic buying’ type advance during which prices rise almost vertically, increasing considerably in a very short time

    Check a long-term chart of the Nasdaq Composite with monthly candles and tell me if that doesn’t spell “parabolic”.

    The blow-off move is coming. This is typical of bubbles. By the time the most speculative phase begins, the fundamentals (i.e. earnings) are already deteriorating. The crash might be historic.

  • Hi Pater,

    Great article. What are your thoughts on the idea that margin debt is only relevant compared to total market cap? As explained here: http://philosophicaleconomics.wordpress.com/2013/10/25/margin-debt/

    • In principle I agree with the contention that margin debt is not a timing tool – we cannot say a priori to what levels it will rise prior to the peak. However, I disagree that this means it should simply be ignored and I vehemently disagree that market cap – i.e. the value of assets which has inter alia been driven higher by the expansion of this debt – is relevant in assessing the dangers. This is the kind of argument we regularly heard when criticizing the housing bubble and the low savings rates that pertained at the time. Apologists of the bubble kept arguing that ‘net debt’ was low because the value of assets (such as houses and stocks) had risen so much. They ignored the fact that when asset values decline, the debt remains unchanged and becomes a millstone around the necks of debtors. In the stock market, margin clerks appear on the scene and the higher the margin debt, the more forced selling there will be. The danger is not minimized by the fact that market caps have increased a lot, since debt has risen along with the increase in market cap, so the effect of forced selling will definitely snowball.
      Also, the rise in debt and valuations must be seen in context – apart from the factors discussed above, it should be noted that the rally in stocks has been due to an expansion in multiples over the past 18 months or so, as earnings growth has begun to stall. So we not only have record high margin debt, we have it at a time when valuations are at levels that compare to the levels seen at several major historical tops, and at a time when all sorts of other warning signs have become evident as well.

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