Six years after the Global Financial Crisis, the U.S. stock market continues to soar to new heights with nary a pullback or correction. In this piece, I will explain why the stock market is experiencing a new bubble that is actually another wave of the bubble that has existed since the mid-1990s.
A two-decade old bubble? Yes, you've read that correctly. Most people will consider this assertion preposterous, but the facts don't lie. Though the U.S. stock market has been experiencing a bubble for two decades, it will not last forever. I believe that the ultimate popping of this bubble will have terrifying consequences for both investors and the global economy that is tied so closely to the stock market.
The SP500 stock index has more than tripled since its low in 2009, but that doesn't mean that we are out of the woods. On the contrary, this is the calm before the storm.
Source: St. Louis Fed
Since the mid-1990s, the U.S. economy and stock market has experienced three different bubbles: the 1990s Dot-com bubble, the mid-2000s housing bubble, and now another bubble that includes stocks, bonds, tech startups, certain segments of the housing market, higher education, and much more. I believe that this new bubble is creating what I call a "Bubblecovery" or a bubble-driven temporary economic recovery that will end in another crisis.
The U.S. Federal Reserve also created a Bubblecovery in the early-2000s to recover from the Dot-com bust, which led to the housing bubble. After the housing bubble burst, the Fed inflated the post-2009 Bubblecovery. After each bubble/Bubblecovery ends, the Fed simply inflates another bubble to recover from the last one. In essence, the U.S. economy and stock market has been in a bubble cycle for the past two decades. Each time, the bubble gets larger, and the Fed has to keep re-inflating it to avoid the economic Depression that would occur if asset prices were allowed to find their true value.
The incessant push to inflate our economy and financial markets has created an unprecedented situation in which stocks have been trading at overvalued levels for a record length of time. Nearly every stock market valuation indicator is giving the same reading: stocks are currently at levels that preceded other major historic busts.
For example, look at the Cyclically Adjusted P/E Ratio (CAPE), or the price-to-earnings ratio based on average inflation-adjusted earnings from the previous 10 years. The 1929 Stock Market Crash and 1970s stagnation occurred after the CAPE rose over 20 - a level that indicates stock market overvaluation. Incredibly, the CAPE has remained over 20 for much of the past two decades, aside from a few short months during the Global Financial Crisis. Without constant Fed intervention, there is no doubt that the U.S. stock market would have corrected violently like it has in the past.
Source: VectorGrader.com
While some stock market bulls dismiss the CAPE (likely because it doesn't fit their "stocks are cheap!" narrative), here is another valuation measure giving the same reading. The Price-to-Peak Earnings Ratio, or the current price of the S&P 500 divided by the highest level of earnings achieved to-date, shows that U.S. stocks have been overvalued since the mid-1990s as well.
Source: VectorGrader.com
Tobin’s Q Ratio (the ratio of the market’s price to replacement costs) also shows that U.S. stocks have been overvalued for two decades:
Source: VectorGrader.com
The total market capitalization-to-GDP ratio, which Warren Buffett claimed is “probably the best single measure of where valuations stand at any given moment," tells the same story:
Source: VectorGrader.com
Dividend yields - which move inversely with stock valuations - have also been at record lows since the mid-1990s. The mainstream narrative explaining this phenomenon is that companies now prefer to re-invest their earnings instead of pay dividends, but this explanation is fishy because dividend yields are giving the same exact reading as the other valuation indicators shown in this piece. There is likely some degree of truth to the mainstream explanation, but I believe that the market overvaluation thesis is the most convincing.
Source: VectorGrader.com
The key takeaway is that overvalued financial markets are not sustainable and must eventually experience a correction that returns them back to their fundamental value. In a free market (unlike what we have now), stock valuations move in waves, alternating from undervaluation to fair valuation to overvaluation, and back again. The Federal Reserve, by trying to keep the bubble constantly inflated, has distorted this natural process. Regardless, U.S. stocks will come back to earth when the Fed finally loses control of the situation, and the final comedown will be far more painful than would occur in a free market.
How has the Fed kept the stock market inflated for so long? One way is by steadily cutting its benchmark Fed Funds Rate to an all-time low and holding it there for an unprecedented length of time. Interest rates have been falling since the early-1980s, and their low levels in the past two decades have helped to buoy stock valuations. Low interest rates fuel asset bubbles because it makes saving (or holding cash) less attractive than investing in riskier assets like stocks that are rising at a rapid rate.
Source: St. Louis Fed
The yields on most bonds (such as U.S. 10 year Treasuries shown below) have been falling in tandem with the Fed Funds Rate. Low interest rates allow corporations and households to borrow cheaply, which is what got U.S. homeowners and consumers into trouble during last decade's bubble. The same shenanigans is occurring today as corporations binge on debt to invest in projects, buyouts, and stock buybacks - many of which will prove to be malinvestments when interest rates finally rise again.
Source: St. Louis Fed
Record low interest rates have also encouraged speculators to borrow on margin to buy stocks, as they have during the last two bubbles, and before the 1929 Stock Market Crash. The heavy use of margin has helped to keep stock valuations inflated for the past two decades.
Source: Doug Short
After the Financial Crisis, the Fed became increasingly desperate to re-inflate the bubble that was trying to fall on its own weight, so it took steps that it didn't take during the late-1990s and mid-2000s bubbles: it resorted to outright money printing to pump liquidity into the economy and financial markets. As the chart below shows, the Fed created nearly $4 trillion worth of new money via its quantitative easing programs. Each QE injection led to a corresponding surge in stock prices.
Source: St. Louis Fed
Record low interest rates have dramatically reduced corporate borrowing costs, so large companies have been borrowing from the bond market and buying back their own stock, further inflating the two decade-old stock bubble. SP500 companies have bought back $2 trillion worth of their own stock since 2009 and $6.9 trillion in the past decade.
Source: FactSet Fundamentals
The Fed's efforts to maintain the two decade-old stock bubble are working, and naïve investors are buying it hook, line, and sinker. The percentage of bearish investors (a contrarian indicator) has hit a multi-decade low of just 16 percent, which is far lower than during the Dot-com and housing bubbles.
Source: @Not_Jim_Cramer
In the past two decades, billionaire value investor Warren Buffett has remarked several times that he has been unable to find quality undervalued companies to invest in. Though he never explained why this was the case, I believe that my "two decade-old stock bubble" thesis explains it perfectly. Warren Buffett's most profitable long-term investments that put him on the map were made in the 1970s and 1980s, which were a time of very low stock valuations and, therefore, excellent deals for bargain hunters like Buffett.
While the Fed is in control of the stock bubble for now, this won't always be the case. Stock valuations and prices must come back to reality, and when they do, it's going to shake the entire global financial system to its core. Because of the high ownership of stocks in our country, the two decade-old stock bubble means that American wealth itself has been in a bubble. Pensions, 401(k)s, and other investment accounts are loaded up on an asset that is worth a fraction of what it is currently valued at. The masses are banking their future and retirements on a house of cards, and are completely oblivious.
The wildly inflated stock market is the reason why we currently have a tech startup and IPO bubble, and the concomitant frenzy and fascination associated with Silicon Valley startup culture. The stock market's high valuation spurs the formation of whimsical enterprises (see tech "unicorns") and encourages them to go public at sky-high valuations that would never make sense if stock valuations were at more reasonable levels.
Because of the highly precarious bubble situation I've shown in this piece, I simply refuse to "buy and hold" stocks until this two decade-old bubble pops for good. I am not saying that this stock bubble will pop immediately, and I realize that this bubble can grow far larger before it pops due to the sheer will of the Fed alone. Though I will not blindly invest in this bubble, I believe that a short-term tactical approach may be warranted, as I discussed here.
I believe that the longer-term U.S. stock bubble will end when the very fuel behind it is removed, which is record low interest rates. As I discussed in my last stock bubble report, I foresee two ways that rates will rise and pop the stock bubble:
Scenario #1: After several more years of the Bubblecovery or bubble-driven economic recovery, the Federal Reserve has a “Mission Accomplished” moment and eventually increases the Fed Funds rate too high, creating a hard landing that pops the post-2009 bubbles that were created by stimulative monetary conditions in the first place. Rising interest rates are what ended the 2003-2007 bubble, which led to the Global Financial Crisis.
Scenario #2: The ballooning and unsustainable amount of government and corporate bond market debt eventually causes investors to jettison bonds en masse, which leads to much higher interest rates.
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(Disclaimer: All information is provided for educational purposes only and should not be relied on for making any investment decisions.)
