July 16, 2016, Weekly Summary: A Tail of Two Bubbles

A Tail of Two Bubbles

Last week, we outlined some of the fundamental reasons for concern about stock valuations, and even though there are many more economic reasons to be worried, we will present just two more indicators that highlight the questionable valuation of stocks.

The chart below shows the S&P 500 relative to global liquidity. Liquidity moves markets more than earnings, and negative liquidity always leads to down markets. In 2000 and 2007, negative liquidity resulted in full-blown bear markets, while in 2011 it produced a serious correction within the on-going bull market. Since the bull market is in its seventh year, the situation may have more in common with 2000 and 2007 than 2011, but that remains to be seen.
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The bond market is the clearest example (equities market close behind) of the “greater fool” theory that we have ever witnessed (especially in Japan). Hedge funds keep buying bonds, even though sometimes the prices paid give a negative yield, because they know that the central banks will buy them back at higher prices. In other words, they have a guaranteed official “greater fool” to sell to. This is the stuff that bubbles are made of.

The next chart is a 35-year chart of the S&P 500 and the 10-year bond yield (yield is inverse to price).

july 14 bubbles

What you are looking at, is two of the biggest bubbles that the world has ever inflated. Can they continue to get bigger? Since bubbles form because they are disconnected from the real economy, they certainly can keep growing, but at some point they burst and release a whole lot of trouble.

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The next two charts show how the counter-trend pattern of low bull sentiment at market tops has been a harbinger of corrections in the past.
july 14 bull sentiment 2007
july 14 bull sentiment 2016

There is a possibility that the present situation is more similar to 1998 (chart below) than it is to 2007. At that time, the market corrected, then ballooned into the dot-com bubble over the next two years before repeating the low bull sentiment pattern at the 2000 top that lead to the bear market.

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The Rydex Bear:Bull Asset ratio (chart below) continues to indicate a change in direction from the first half of the year. This may be a continuation of the bubble.

july 13 bear to bull

Also signaling a possible reversal to the upside is the long-term study (chart below) of the MACD, RSI, and the 8 and 12 month averages for the SPX. The fact that it has occurred on low volume gives this pattern-reversal less gravitas, as does the fact that a MACD reversal in 2011 (to the downside) was only temporary. Something similar may be in play here also. Again, this gives us pause and lowers the probability of a near-term breakdown, but does not eliminate it.

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This past week, the BOE said they were not cutting rates, but to expect a rate-cut next time (August). That was ‘good enough’ for a market that is focused on lower rates, especially since the minutes of the meeting are setting the stage for much more than just a rate cut; mainly asset purchases. They want to see how bad things are likely to get before they work their monetary magic. The markets continued to climb as if everything was just fine, since there is nowhere else to put money to work….the game of musical chairs continues.

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As Benjamin Graham wisely observed decades ago,
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Gold

As we stated last week, if gold failed to close above $1400, then it was likely to consolidate, and that is what happened; gold followed the 30-year bond lower.

July 14 gold 30-y bond

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The commitment of traders showed that both the large speculators and the commercial traders reduced their positions slightly for the week ending July 12. This was the first reduction in positions in the past six weeks.

july 14 gold price july 14 commitment of traders