This mighty stock bull born way back in March 2009 has proven exceptional in countless ways. As of mid-June, the flagship S&P 500 broad-market stock index (SPX) has powered 262.7% higher over 8.3 years! Investors take this for granted, but it’s far from normal. That makes this bull the fourth-largest and second-longest in US stock-market history! And the few superior bull specimens vividly highlight market cyclicality.
The SPX’s biggest and longest bull on record soared 417% higher between October 1990 and March 2000. After it peaked in epic bubble-grade euphoria, the SPX soon yielded to a brutal 49% bear market over the next 2.6 years. The SPX wouldn’t decisively power above those bull-peaking levels until 12.9 years later in early 2013, thanks to the Fed’s unprecedented QE3 campaign! The greatest bull didn’t end well at all.
The second-largest bull was a 325% monster between July 1932 to March 1937. But that illuminated the inexorable cyclicality of stock markets too, as it arose from the ashes of a soul-crushing 89% bear in the aftermath of 1929’s infamous stock-market crash. The third-largest bull was 266% from June 1949 to August 1956, which we’ve almost surpassed. And even that post-WW2 boom was followed by another bear.
All throughout stock-market history, this binary bull-bear cycle has persisted. Though some bulls grow bigger and last longer than others, all eventually give way to subsequent bears to rebalance sentiment and valuations. So stock investing late in any bull market, which is when investors complacently assume it will last indefinitely, is hyper-risky. Bear markets start at serious 20% SPX losses, and often approach 50%!
Popular psychology in peaking bull markets is well-studied and predictable. Investors universally believe “this time is different”, that some new factor leaves their bull impregnable and able to keep on powering higher indefinitely. This new-era mindset fuels extreme euphoria and complacency, with memories of big selloffs fading. Investors’ hubris swells, as they forget markets are cyclical and ridicule any who dare warn.
To any serious student of stock-market history, there’s little doubt today’s stock-market situation feels exactly like a major bull-market topping. All the necessary ingredients are in place, ranging from extreme greed-drenched sentiment to extreme near-bubble valuations. If this bull was merely normal, the risks of an imminent countertrend bear erupting to eradicate these late-bull excesses would absolutely be stellar.
But the downside risks in the wake of this exceptional bull are far greater than usual. That’s because much of this bull is artificial, essentially a Fed-conjured illusion. And that was even before the incredible recent Trumphoria surge in the wake of Trump’s surprise victory! Back in early 2013 as the SPX was finally regaining its previous bull’s peak, the Fed unleashed its wildly-unprecedented open-ended QE3 campaign.
Understanding the Fed’s role in fomenting this anomalous stock bull is more important than ever. Not only is the Fed deep into its 12th rate-hike cycle of the past half-century or so, it’s discussing starting to normalize its grotesque QE-ballooned balance sheet. Investors in a largely-artificial quantitative-easing-fueled late-stage stock bull ought to be terrified by the prospects of quantitative tightening soon being unleashed!
The Fed’s QE
This anomalous stock bull was again birthed
Back in early 2009 stock-market valuations were so low after the panic that a new bull was fully justified fundamentally. And its first four years or so played out perfectly normally. Between early 2009 and late 2012, this bull market’s trajectory was typical. It rocketed higher initially out of deep bear lows, but those gains moderated as this bull matured. And its upside progress was punctuated by healthy major corrections.
Those early bull years’ major corrections coincided exactly with the ends of the Fed’s first and second quantitative-easing
Quantitative easing involves creating new money out of thin air to buy up bonds, effectively monetizing debt. While QE1 and QE2 certainly caused market distortions, both campaigns had predetermined sizes and durations. When traders knew a particular QE campaign was nearing its end, they started selling stocks which drove the major corrections. So the Fed decided to change tactics when it launched QE3.
As the SPX approached 1450 in late 2012,
QE3 was radically different from QE1 and QE2 in that it was totally open-ended. Unlike its predecessors, QE3 had no predetermined size or duration! So stock traders couldn’t anticipate when QE3 would end or how big it would get. Stock markets surged on QE3’s announcement and subsequent expansion a few months later. Fed officials started to deftly use QE3’s inherent ambiguity to herd stock traders’ psychology.
Whenever the stock markets started to sell off, Fed officials would rush to their microphones to reassure traders that QE3 could be expanded anytime if necessary. Those implicit promises of central-bank intervention quickly truncated all nascent
This stock bull went from normal between 2009
QE3 was finally wound down in late 2014, leading to the Fed-conjured stock bull stalling out. Without central-bank money printing behind it, the stock-market levitation between 2013 to 2015 never would have happened! One of the most-damning charts
Without the Fed’s QE
Heading into late June last year, Wall Street was forecasting a sharp global stock-market
So this tired old bull again started surging to new record highs in July and August, although they were not much better than May 2015’s. After that euphoric surge on hopes for post-Brexit-vote central-bank easings, the SPX started to roll over again heading into the US presidential election. Again Wall Street warned just like Brexit that a
The shocking post-election stock surge has been called a Trumpgasm, or Trumphoria. Capital flooded into stocks for a variety of reasons. In addition to hopes for
This exuberant psychology greatly intensified this year, with the SPX periodically surging to
But this Fed-goosed stock bull was already very long in the tooth, and stock valuations
Between the SPX’s original top soon after QE3 ended in May 2015 and Election Day 2016, at best stock markets simply ground sideways. At worst they were rolling over into what should’ve grown into a major new bear.
An ominous side effect of that anomalous late-bull surge was extremely-low volatility, with all kinds of low-volatility records set. The VIX S&P 500 implied-volatility index on this chart reflects that, slumping to multi-decade lows in recent months! Low volatility reflects low fear and high complacency, the exact herd sentiment ubiquitous at major bull-market toppings. Just like stock markets, volatility is forever cyclical too.
Volatility often skyrockets off exceptional lows, as the great sentiment pendulum must swing back to fear after peaking deep in the greed side of its arc. And the only thing that generates fear late in stock bulls is sharp
When the last stock bulls peaked in March 2000 and October 2007, there was no specific news that killed them. Lofty euphoric stock markets simply started gradually rolling over, mostly through relatively-minor down days which generated little fear. These modest grinds lower kept most investors unaware of the waking bears, boiling them slowly like the proverbial frog in the pot. But even little losses eventually add up.
Since nearly all the amazing stock-market gains between late 2012 to mid-2015 were directly fueled by the Fed’s QE3 money printing, fears of the coming quantitative tightening may prove the bull-slaying catalyst. The Fed conjured money out of thin air to buy bonds in QE, and it will destroy that very money by selling bonds in QT. QT’s capital outflows should prove as bearish for stocks as QE’s inflows were bullish!
The FOMC actually started discussing QT at its early-May meeting, and is planning to start implementing to begin unwinding the QE bond monetizations later this year. Prudent investors will anticipate QT even before it begins, and plenty will pre-emptively sell. QT has profoundly-bearish implications for these QE-boosted stock markets. The unwinding of the Fed’s massive QE-bloated balance sheet is unprecedented.
Back in the first 8 months of 2008 before that stock panic, the Fed’s balance sheet averaged $849b. By February 2015, it had ballooned to a freakish $4474b. That’s up a staggering 427% or $3625b over 6.5 years of QE! QE levitated the stock markets in two primary ways. That Fed bond buying bullied yields to artificial lows, forcing bond investors starving for yields to buy far-riskier stocks that were paying dividends.
More importantly, those unnatural contrived extremely-low yields courtesy of QE fueled a boom in stock buybacks by corporations unlike anything ever witnessed. American companies took advantage of the crazy-low interest rates to literally borrow trillions of dollars to buy back their own stocks! Between QE3’s launch and Trump’s victory, corporate stock buybacks were the dominant source of stock-market capital inflows.
QT along with the Fed’s rate-hike cycle will allow bond yields to rise again, eventually greatly retarding corporations’ desire and ability to borrow vast sums of money to use to manipulate their own stock prices higher. In late June, the Fed’s balance sheet was still way up at an extreme $4430b. These QE-inflated stock markets have never experienced QT, and it
While the Yellen Fed is far too cowardly to fully reverse $3.6t worth of QE since late 2008, even a trillion or two of QT over the coming years is going to wreak havoc on these QE-levitated stock markets. That’s a serious problem for today’s extreme Fed-goosed bull with a rotten fundamental foundation. Underlying corporate earnings never supported such extreme record stock prices, and the coming reckoning is unavoidable.
Regardless of the Fed’s balance sheet, quantitative tightening, or valuations, the near-record-low VIX
And investors aren’t taking the threat of a new bear seriously. Crossing the bear threshold just requires a 20% retreat. Even such a baby bear would erase all SPX gains since mid-2014. A normal bear market at this stage in the Long Valuation Waves is actually 50%, cutting stock prices in half! That would wipe out the great majority of this entire mighty stock bull, dragging the SPX all the way back down to mid-2010 levels.
Even more ominously, bear markets naturally following bulls tend to be proportional. That makes sense
And that finally brings us to valuations, this old stock bull’s core problem. This next chart looks at the SPX superimposed over a couple key valuation metrics. Both are derived from averaging the trailing-twelve-month price-to-earnings ratios of all 500 elite SPX companies. The light-blue line is their simple average, while the dark-blue one is weighted by market capitalization. Today’s valuations ought to terrify investors.
Wall Street also plays a deceptive
That is based on generally-accepted accounting principles (GAAP) which are required when companies actually report to regulators. The only righteous way to measure price-to-earnings ratios is using the last four quarters of GAAP profits, or trailing twelve months. Those numbers are hard, established in the real world based on real sales and real expenses. They are not mere estimates like totally-bogus forward earnings.
Every month at Zeal we look at the TTM P/Es of all 500 SPX companies. At the end of May, the simple average of all SPX companies actually earning profits so they can have P/Es was an astounding 27.5x! That is nearly in bubble territory, just as Trump had warned about during his campaign. 14x earnings is the historical fair
If you study the history of the stock markets, stock
During secular bears, stock prices grind sideways on balance for long enough for earnings to catch up with lofty stock prices. Before QE3 temporarily broke stock-market cycles, that process had been happening as normal between 2000 to 2012. Secular bears don’t end until valuations get to half fair value, 7x earnings. So instead of being near bubble levels, valuations would normally be between 7x to 10x today.
That’s the massive downside risk stocks face due to their Fed-conjured bubble valuations! While the red line above shows the actual SPX, the white line shows where it would be trading at 14x fair value. Even that is way down around 1245 today, roughly half current levels. But mean reversions from extremes nearly always overshoot in the opposite direction, so the potential SPX bear-market bottom is much lower.
The more expensive stocks are in valuation terms when they are purchased, the worse the subsequent returns will be. And no matter how awesome Trump’s policies may ultimately prove, they aren’t going to rescue corporate profits anytime soon. With all Trump’s political turmoil and the Republican lawmakers’ unproductive infighting, the big tax
In the meantime, corporate profits face major headwinds in the coming quarters that are likely to leave stock valuations even more extreme. Q1’17 corporate earnings surged almost certainly due to all the Trumphoria optimism. Between hopes for big tax cuts soon, and the wealth effect from record-high US stock markets, spending was far beyond normal. That will mean revert lower as hard political realities set in.
All kinds of hard economic data have already started deteriorating considerably since peak Trumphoria hit as March dawned. The consumers and companies spending big in the first quarter on hopes for big tax cuts soon are starting to pull in their horns. That will likely result in weaker corporate-
The stock markets’ lofty valuations before the Trumpgasm and near-bubble valuations since are a very serious problem that can only be resolved by an overdue major bear market! Only that will drag stock prices low enough to where existing and future corporate earnings will support reasonable valuations again. Investors don’t believe a new bear market is possible, but they never do when bull markets are topping.
Investors really need to lighten up on their stock-heavy portfolios, or put stop losses in place, to protect themselves from the coming valuation mean reversion in the form of a major new stock bear. Cash is king in bear markets, as its buying power increases as stock prices fall. Investors who hold cash during a 50% bear market can double their stock holdings at the bottom by buying back their stocks at half price!
Put options on the leading SPY S&P 500 ETF can be used to hedge downside risks. They are cheap now with euphoria rampant, but their prices will surge quickly when stocks start selling off materially. Even better than cash and SPY puts is gold, the anti-stock trade. Gold is a rare asset that tends to move counter to stock markets, leading to soaring investment demand for portfolio diversification when stocks fall.
Gold surged nearly 30% higher in the first half of 2016 in a new bull run that was initially sparked by the last major correction in stock markets early last year. If the stock markets indeed roll over into a new bear in 2017, gold’s coming
Absolutely essential in bear markets is cultivating excellent contrarian intelligence sources. That’s our specialty at Zeal. After decades studying the markets and trading, we really walk the contrarian walk. We buy low when few others will, so we can later sell high when few others can. While Wall Street will deny the coming stock-market bear all the way down, we will help you both understand it and prosper during it.
We’ve long published acclaimed weekly and monthly newsletters for speculators and investors. They draw on our vast experience, knowledge, wisdom, and ongoing research to explain what’s going on in the markets, why, and how to trade them with specific stocks. As of the end of Q1, all 928 stock trades recommended to our newsletter subscribers in real-time since 2001 averaged
The bottom line is today’s euphoric near-record stock markets are hyper-risky. They are trading near bubble valuations thanks to the stunning post-election rally. Such lofty stock prices are risky any time, but exceedingly dangerous late in an enormous bull market artificially extended by the Fed. A major new bear market is long overdue that will at least cut stock prices in half. Don’t be fooled by
Prudent investors have to overcome this
- Source, Silver Doctors