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Thursday, June 26, 2014

Signs of a bull market top

History tells us there are some things that commonly occur at bull market tops.  I have put together a list so we can see how the current situation compares.  Not every element of this list occurs at every top.  That is part of the reason tops can be hard to spot.  The other part of the reason is because of item number 1 in the list.

1. Sentiment - The one element that occurs at virtually every top is a very common belief that the market can only keep going up.  This is largely caused by the market ignoring everything that should be causing it to go down.  No sign of that here (he typed with an amazing amount of sarcasm in his thoughts).  In Daily update 6/5 I showed the II sentiment survey with the number of bulls at the same level as the 2007 top.  Here is a survey of professional investors.

This chart shows professional investors are the most bullish they have been in this entire bull market.  It is about the same level as the Oct. 2007 top.  Clearly this survey is unusually high.  Lets look at what people are actually doing with their money.  Here is a chart of the latest margin debt data.

Not only is margin debt at a record high in actual dollars even adjusted for inflation it made a record high.  People do not load up on margin without being very bullish do they?  Here is a look at margin debt vs GDP.

This chart isn't quite up to date, but it has a lot of data.  This chart clearly shows that people got very enamored with the stock market starting in the mid 90s.  Despite two 50% crashes people are still enamored.  Even at the depths of the last two bear markets the debt stayed above previosly high levels.   Here is a more up to date chart.

Back in Jan. we eclipsed 2.5% of GDP.  This is only the third time in the history of margin debt data collection that happened.  It is now about the same level as 2007.  We know what happened the other two times.  Will it be different this time?  Here is a chart I have never seen before.  It is a ratio of money in equities vs money market funds (the much talked about cash on the sidelines).

Like margin debt this ratio is at record highs.  This is what people have done with real money, not what they say.  Doesn't this ratio indicate there is less available sideline money then at the other tops?  While the pundits keep saying this is the most hated bull market in history the data says otherwise.  One could argue it is actually a very much loved bull market.  What people don't like is the economy. 

I think it is clear we can put a check mark in the overly bullish item on the checklist.

2. Over valuation - Another characteristic of bull market tops has been an over valued market.  There are several different ways to look at that.  Lets start with Warren Buffet's favorite method.  I think we can all agree he is a pretty good investor.

This valuation measure has surpassed the valuation at the 2007 top.  It was only surpassed by the 2000 top.  Can we count on people being that crazy again?  Notice where we were in 1994.  That was twelve years after the secular bull market started in 1982 and valuation was still not excessive by historical standards.  What a difference the next six years made.  I have seen many people compare now to the 1995 period and claim there are years of upside ahead.  As you can see we are not really like that time period at all.  We look pretty over valued already don't you think?  Here is a look at Tobin's Q ratio.

We can see that going back to 1900 stocks have only been more over valued one time in history.  This measure is well above the 2007 peak.  Not cheap by any stretch of the imagination with this metric.  Here is a look at a composite indicator of four different valuation metrics.

With this method we currently have the third most over valued market since 1900.  I think everybody knows what happened those other two times (1929 and 2000).

I think we have enough evidence to put a check mark in the over valuation check list item.

3. Investors ignoring fundamentals - This one is obviously going on.  Last year we had 5% growth in profits and 1.9% economic growth (stall speed) while the market was up 30%.  This year we had a huge drop in Q1 profits and a -1% GDP print (now -2.9, but that just came out) and yet SPX made new highs.  Does that really make sense?  The only time in history we had 4 quarters of growth less then 2% without going into a recession was 2011.  Can we be that lucky again?  We also had a big drop in profits that 7 out of 8 times has preceded a recession.  Shouldn't investors be at least a little cautious?  Here is the chart in case you missed it.

Despite the consensus that a recession is not possible this year the data says that it is entirely possible we are already in one or heading that way. With an over valued market people should be at least a little worried.  On top of the possible economic fundamentals we have an unsettled geo political situation.  There is at least a moderate risk of higher oil prices which would be a drag on the economy.  I think we can put a check mark in the ignoring fundamentals check list item.  I am sure some people will disagree on that.  However, I would argue that stocks are priced for perfection and anything less then that could be a problem.

4. Froth (greed) is taking over - This one is a little hard to define exactly.  What is froth?  This year the Russell2000 small cap index had a P/E over 100.  That is about what the NDX100 had in 2000.  That seems a little like froth doesn't it?  This year I have seen a number of very low volume under $10 stocks making huge moves (100% or more in days).  I saw this exact same behavior in 2000.  I did not notice that so much in 2007.  Not sure if I just missed it or it wasn't there.  There was plenty of froth in the housing and commodities markets though.  Here is a look at trading in the junk bulletin board stocks.

These are stocks that don't have fundamentals worthy of trading on the major exchanges.  They are truly junk.  There was froth last year, but not as much as 2011 and this year.  I saw a better chart that was based purely on volume instead of value on TV last month.  It showed a huge jump in volume this year that was way above everything the last several years.  Unfortunately I have been unable to find that chart online.  Here is another chart that shows excess speculation.

This chart is from the middle of last year so it is not up to date.  The 25th lowest price stock today is over $18 marked approximately by red horizontal line.  That puts us slightly above the 2007 high.  The 26th lowest price stock is even over $19.  Notice the range of this chart after the 1974 low.  It never crossed the 16 threshold until the late 90s.  People showed caution after the 73-74 bear market and did not fully embrace market speculation until the 90s.  That backs up the same conclusion mentioned above on the margin debt chart.  This is clearly very high and shows excess speculation.

As further examples of froth in the form of rampant speculation we have bitcoin and athlete stocks.  I saw Vernon Davis of the S.F. 49ers one day being interviewed about a stock based on his personal earnings.  The very idea that we have a buyable stock based on one single athlete just completely boggles my mind.  That is taking froth to an entirely new level never before seen.

I believe we have enough evidence to put a check mark in the froth check list item.

5. Surge in M&A and IPO activity - We have seen a lot of merger activity this year.  The recent announcement of the T and DTV deal is just icing on the cake.  Anybody remember the ridiculously overpriced deal between AOL and Time Warner in 2000.  The T deal is just one of many big acquisitions announced this year.  We are on pace to have the most IPOs since 2000.   There has been a flood of unprofitable IPOs over the last six months.  Check out this chart.

We recently have had about the same percentage of IPOs with negative earnings as we saw at the 2000 top.  Is that smart money trying to cash in while the getting is good?

There is no doubt in my mind that this check list item gets a checkmark.

6. Complacency - This is a category that is hard to quantify.  To me it is not the same as low volatility.  It is kind of like sentiment in some ways.  I define it more as a feeling that the market cannot go down in a big way.  That can be fostered by low volatility, but I have seen low volatility environments where people were still worried about a big move down.  I recently saw some comments that the FED is worried about complacency.

Federal Reserve officials are worried that when it comes to financial markets, this could be the calm before the storm.

The stable market environment has Fed officials concerned that investors will take on too much risk. "Volatility in the markets is unusually low," William Dudley, president of the New York Fed, said after a speech last week, according to The Journal.

"I am a little bit nervous that people are taking too much comfort in this low-volatility period. As a consequence, they'll take more risk than really what's appropriate."

Richard Fisher, president of the Dallas Fed, is also concerned about complacency in the market. "Low volatility I don't think is healthy," he said in an interview Tuesday, The Journal reports. "This indicates to me a little bit too much complacency that [interest] rates are going to stay at abnormally low levels forever."

I can't even count the number of people I have seen get on TV proclaiming they don't see any significant downside risk.  Complacency may be a little like pornography.  I may not know exactly how to define it, but I know it when I see it.  Listening to people talk I believe there is absolutely a high degree of complacency in the markets today.  I think this line item deserves a check mark.

7. Topping chart patterns - This of course is the most important item in the list.  However, you don't actually get it until after the top has happened.  In this case the Dow completed what looks like a three peaks and a domed house well known topping pattern back in Dec.  However, the Dow has climbed above that high.  That has happened before and the Dow went on to make the expected decline.  Other then that it is really too early to tell much.  This is always the trickiest part of the whole thing.  Each bull market top looks somewhat different.  There is no single formula that can be applied.  We can't put a check mark in this item at the moment.  We need to see some actual price decline first.  Of course there is the possibility that taking profits has been outlawed and the market will never ever go down ever again.

It is quite clear to me that despite two major crashes in such a short period of time people are still enamored with stocks.  The pundits can say what they want about this being a hated bull market.  It just is not true based on what people are doing with their money.  We have the second or third most over valued market in history.  No lesson was learned on valuation whatsoever.  We are again at nosebleed levels.  The market has never consolidated over valuation at these extremes.  Will history repeat with another big meltdown?  Will it be different this time?  We have the conditions that normally happen around bull market tops.  This seems like a very poor time to put new money to work.  As they say buyer beware.

I saw this from John Hussman the other day and I think it is totally appropriate.

However uncomfortable it might be in the shorter-term, the historical evidence suggests that once overvalued, overbought, overbullish conditions become as extreme as they are today, it’s advisable to panic before everyone else does. 


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The information in this blog is provided for educational purposes only and is not to be construed as investment advice.