Common Sense Living

BEWARE The Stock Market Bubble

I wrote about the stock market being in a “bubble” about a month ago, and as the markets have continued to rise further into the overpriced zone, my “worry meter” is also approaching the red mark.  I believe we are getting dangerously close to a market reversal which could take the major averages down by 30% to 50% over time.

The catalyst for the recent rally beginning last November was the U.S. election, and a belief that Donald Trump was going to deliver tax reform, bring $2 trillion in corporate cash back to the United States, and resolve the costly Obamacare health plan.  Given the failure of Congress to pass any action on Obamacare, along with continuing investigations into possible campaign indiscretions with Russia, the Trump administration is unlikely to make significant progress of any of these initiatives.  Their momentum has been blunted, and along with it, the catalyst for the market increase has also been negated.

Putting politics aside, let’s look at valuation.  The S&P 500 is now approaching a price that is 30-times the annual earnings of the underlying stocks.  This is known as the price-to-earnings ratio, or P/E ratio.  A “normal” P/E ratio for the S&P 500 is in the range of 11 to 15.  So investors today are, for now, willing to pay over twice the price for a stock than they have in the past.

There have only been four times in history where the S&P 500 P/E ratio has exceeded 30.  These were in 2008 (financial crisis), 2000 (tech bubble),  early 1990s (savings and loan crisis), and in 1895 just prior to the 1896 economic depression.  In 1929, the P/E ratio was approaching 30 when the famous stock market crash hit in October of that year, which heralded in the Great Depression of the 1930s.  So valuations today are historically VERY high.

Yesterday, Federal Reserve Vice Chairman Stanley Fischer stated that interest rates are low because the economy was weak.  He cited poor productivity, and weak business investment.  There is much evidence to support his comments.  Thousands upon thousands of stores are closing in the retail industry.

Some suggest the decline in retail is due to online sales at  Unlikely.  Amazon just reported earnings for the quarter that missed expectations.  Furthermore, most of Amazon’s earnings don’t come from retail, but rather their Amazon Web Services (AWS) computing division.

Auto sales, a major engine of growth, have begun pulling back over the past several months.

No doubt, consumer spending is reversing course. Consumer spending makes up nearly 70% of the U.S. economy, and when it gets a cold, the economy feels seriously ill.

Debt in the economy is as high as ever.  Yesterday an article appeared indicating that Denver, Houston, Miami, and Washington DC are again in a housing bubble.

Housing debt is still very high relative to income.  In addition, authorities have been sounding the alarm on bad loans for student debt (now in the trillions of dollars) and auto loans and leases.  So the housing crisis didn’t teach us anything!

Governments are also experiencing financial stresses like never before.  Puerto Rico is in bankruptcy and has defaulted on debt.  Illinois is on the brink.  Connecticut, Rhode Island, and Vermont are also right behind.

With high debt, stretched finances, and overpriced markets, it won’t take much to see a reversal in fortunes.  Furthermore, when the house of cards begins to cave, it is unlikely Washington will have the funds or willpower to step in and rescue the economy the way they did the last time.

This time around, the system may have to let the defaults play out.  None of that is good for the stock market!  I like gold instead.

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