The recent stock market volatility has caused the major averages to lose nearly
all their gains for 2015. However, it is clear stock prices are still extremely
overvalued by virtually every metric, especially when viewed in the absence
of GDP and earnings growth.
For starters, the Cyclically Adjusted PE Ratio on the S&P 500 is currently
27, whereas the normal level for this longer-term valuation metric is just
15. Also, the ratio of Total Market Cap to GDP is currently at 125%. This reading,
which measures the value of all stock prices in relation to the economy, is
the second highest in history outside of the tech bubble and is far above the
110% level witnessed in 2007. And with a median PE ratio of all NYSE stocks
at a record-high 22, there can''t be any doubt that stock prices are at extreme
valuations.
But these lofty valuations sit atop negative earnings growth and a faltering
economy. The Atlanta Fed''s GDP model currently shows Q1 2015 economic growth
will come in at a paltry 0.2% annualized rate. And S&P Capital IQ predicts
Q1 earnings will fall 2.9%, while also projecting Q2 earnings growth will contract
1.8%.
So how can stock prices remain at record high valuations; given the fact such
levels seem egregiously ridiculous within the context of no growth? The answer
is simply that central banks have given investors no other alternatives. Banks
pay you zip on your deposits and sovereign debt offers little return--even
when going out 10 years on the yield curve.
Central banks have forced investors to play musical chairs with their money;
but this dangerous game has millions of players and just a handful of chairs.
When the music finally stops investors will find that bids for stocks have
become very rare.
There are three very specific conditions that will warn investors when a spike
is about to be driven through this massive equity bubble -- and, if heeded,
will give you a chance to pounce on one of those few remaining bids for stocks
at these incredible levels.
The first is a U.S. recession. To be clear, domestic growth in Q1 will already
be close enough to zero to get us halfway to a recession. The carnival barkers
on Wall Street have jumped on the weather excuse once again and have bought
the markets of few more weeks. However, once April economic data is announced,
it must clearly display to investors that first quarter''s flat GDP print was
simply caused by another cold winter. If it does not, the negative earnings
growth in Q1 will then be extrapolated to Q2 and will convey to investors that
the Fed was unsuccessful in providing sustainable growth after 7 years of ZIRP.
Now that QE is no longer levitating stocks (and the Fed is actually threatening
to raise interest rates), the markets will finally succumb to the massive weight
of record-high valuations that have been erroneously built on top of anticipated
rapid growth that never materialized. If April''s data on Durable Goods, Industrial
Production, Factory Orders or Retail Sales is reported with a minus sign, investors
should run for the exit.
The second indicator that the equity bubble is about to explode will be if
the Fed actually starts raising rates. Of course, some pundits will be quick
to point out that just one 25bps rate hike won''t be enough to derail the equity
bubble because rates will still be very low. However, the Fed will be embarking
on a rate hike campaign into a market cycle of deflation and slowing growth.
Normally, the Fed raises rates to combat inflation, which has started to send
long-term rates much higher. But, this time around the Fed will be hiking rates
just to prove it can get off the zero bound range it has been stuck on since
2008. Or, because the unemployment rate dropped below the Fed''s arbitrary,
Phillips-curve line in the sand, where inflation is supposed to magically materialize.
This means the Ten-year Note, which has already dropped below 2% due to deflationary
forces, would most likely fall even lower. Since the Effective Fed Funds Rate
is currently at .12%, it will only take a handful of 25bps rate hikes before
the yield curve flattens out and banks find it unprofitable to make new loans.
Once this occurs, the money supply contracts and the markets and economy go
into a tailspin. Unless the Fed makes it abundantly clear that its first rate
hike is not part of any protracted campaign, look for investors to quickly
anticipate an inverted yield curve and to start panicking out of stocks.
Finally, the third spike for this market bubble will be if U.S. Benchmark
interest rates were to rise above the 3% level. This could occur if the Fed
is finally successful in creating inflation. Or, more likely, when investors
lose confidence in the U.S. to easily service the debt. Total Non-financial
debt has surged $9.5 trillion (30%) since the Great Recession of 2007. Any
significant increase in borrowing costs would quickly derail the fragile consumer
who is already suffering from a lack of real income growth. And, increased
borrowing costs for the U.S. government would lead to much higher budget deficits.
A Ten-year Note that eclipses 3% would quickly topple the fragile real estate
market and also begin to offer significant competition for stocks. The last
time U.S. rates spiked from 1.5%, to above 3% was April 2013-January 2014.
And this was the real cause for GDP growth to fall to -2.1% in Q1...not the
weather.
Until one of these conditions are met the markets may continue to surge further
into record-bubble territory. However, investors should pay close attention
to April''s economic data, the Fed''s strategy surrounding its first rate hike,
and also keep a close eye on the long end of the yield curve. That is, if they
want to avoid getting consumed by the third massive collapse in equity prices
since 2000.
