The stock market gives us its 2 classic warnings. Will we listen?

Summary: Again the US stock market skates on the edge of an abyss, this time without the Fed holding a safety net. We’ve seen this combination of peaking economy and overvalued stocks; it never ends well. Too bad we don’t learn from history. But I suspect we’ll soon get another opportunity.

The Fed is like the chaperon who orders the punch bowl removed just when the party is warming up.”
— Attributed to William McChesney Martin Jr., Chairman of the Fed from 1951–1970. Those days are long gone.

Pigs running off a cliff

(1)  The biotech party

Here’s the weekly StockCharts view of the exchanged traded fund for the S&P Biotech Index (XBI). The heart of the bubble, it has the classic parabolic rise of an investment mania. Now down almost 30% from its July record high. Propelled by vapors and dreams, we need not consult Nostradamus to guess at what comes next. For details see Don’t ask if there’s a biotech bubble. Ask why we have another bubble.

EFT of the S&P Biotech Index

(2) The social media mania, and Tesla

The stock media stocks are the frothy edge of the bubble. Their boom began with the IPO of Facebook (FB) on 18 May 2012 at $38. It peaked at $99 in July, now at $89 (down 10% from peak). While Facebook has carved out a dominant and profitable niche, most of its scores of competitors remain little but dreams given form by Venture Capitalists — many doomed to die as independent companies when Wall Street has squeezed the last drips of juice from the mania.

Here’s the weekly chart of the Global X exchange-traded fund for the social media industry (SOCL), now fallen 20% from peak to its long-term support — with nothing below but the void. For details see The advertising glut dooms the social media industry.

Global X Social Media Index ETF

Here’s a poster child for the bubble: Tesla Motors (TSLA), a less-than tiny auto company inexplicable worth more than highly profitable giant competitors. Sometimes dreams come true, but that is seldom the best way to bet.

Tesla (TSLA)

(3)  What could go wrong?

From the crash until Q2 of last year the US economy was flying just above the treetops (i.e., stall speed of 2%, below which the risk rises fast of falling into recession — much like an airplane going too slow, generating insufficient lift to stay aloft).  The economy has to grow fast enough for debtors to pay interest and principal on the $31 trillion of private sector debt ($14T of households, $17T of non-financial businesses).

Real GDP YoY

Update: the September ISM report confirms this, with 7 of the 10 categories showing slowing in the manufacturing sector.

The slowdowns in 2011 and 2013 were met by massive government stimulus programs, which worked. That is, they helped stabilize the economy (i.e., they are first aid — not cures).

Now the world economy is slowing as the weakness of China and the oil exporters spreads across the emerging nations, and the US along with it. It’s not the apocalypse the bears so confidently predict (again and again), as shown by the Atlanta Fed’s algorithm-based forecast — which has been rising for the past 6 weeks, moving to match the forecast of carbon-based economists.

GDPnow

But the economy has only a loose and complex relationship with stock prices. It’s the combination of insane overvaluation and a weak economy that creates historical inflection points (like boy and girl rabbits, you need both to make trouble). The result is usually ugly. The peaking of corporate profits provides a spark to the tinder.

To see how ugly it might get, read this analysis by John Hussman (former professor of economics at U MI, now running the Hussman Funds): “Valuations Not Only Mean-Revert; They Mean-Invert“.

(4)  Conclusions

This time there probably will be no government rescue of the economy and stock market, at least action in time to prevent a crash in the frothy parts of the market — and a broad bear market.

How would a stock market crash affect America? Here’s the answer. Also, who will get hurt from the next stock market crash? Not just investors… There is no need for us to repeatedly follow the example of the lemmings in Disney’s famous 1959 film “White Wilderness” (which created the myth of the Lemmings’ suicidal migrations).

(5) Other posts in this series

  1. The stock market gives us its 2 classic warnings. Will we listen?
  2. The US economy flies into the “coffin corner”, but we don’t mind!
  3. How to watch the economy & prepare for the next recession.
  4. The Government’s strange & awesome powers that they’ll use to fight the next recession.
  5. What will cause the next recession?
  6. What can you do to prepare?

(6)  For More Information

If you liked this post, like us on Facebook and follow us on Twitter. See all posts about bubbles, especially these…

Great books about bubbles

Extraordinary Popular Delusions and The Madness of Crowds
Available at Amazon.
Manias, Panics and Crashes
Available at Amazon.

18 thoughts on “The stock market gives us its 2 classic warnings. Will we listen?

  1. Tesla has a classic head and shoulders top (which chartists from the pre-digital age would recognize. Beware!) . Part of its current high valuation may come from the promise of a breakthru in storage batteries for solar power.

    1. Social Bill,

      I’m trying to be more supportive in comments, but can’t let that past. Countless experiments have shown that the reading of patterns in charts of stock prices is quite bogus. This was definitively shown in the 1950s by giving charts to technical analysts for analysis — which they did in a professional manner. But some were charts of random numbers, so the patterns they found existed only in the analysts’ minds. It’s the same as with Rorschach’s ink blots.

      Technical analysis tools provide a powerful way to describe past action of market prices. They give zero information about the future. This is the well-tested and disproven weak version of the efficient market hypothesis.

      It’s a mistaken many experts make. Much of the late 1980s enthusiasm about tactical analysis resulted from assuming stock prices are a normal distribution (more precisely, inadequately adjusting for their non-normality). The brilliant Jack Treynor showed that these tools worked just as well when the prices were randomized (i.e., no long in time sequence).

  2. There many other bubbles: junk bond bubble, student debt bubble, housing bubble has not fully deflate yet, emerging market bubble (biggest bubble is china), corporate bond bubble, treasury bond bubble

    1. you can define bubble as 2 sigma deviation from the mean. Most of these already deviate extremely from the mean. “reading accurate sources” is why you can’t see crash coming.

    2. meofios,

      First, your definition is silly. Mean what? Price trend? one of the many possible definitions of value? Also, US stocks are not “2 sigma away from the mean” by most metrics (depending on the time period used).

      Second, how long have you “seen a crash coming”? Your original comments here in 2013 predicted hyperinflation.

      Third, you obviously didn’t read the post.

    1. meofios.

      The folks at Zero Hedge couldn’t accurately describe the sun rising. Shiller does not say there is a “everything bubble”.

      (1) He says stocks, “bonds and, increasingly, real estate also look overvalued.” Over-valuation is a broader concept than “bubble”.
      Many things are not in a bubble; commodities for example.

      (2) He doesn’t even say stocks are a bubble: “The fact that people don’t believe in the valuation of the market is a source of concern and might be a symptom of a bubble, though I don’t know that we have enough data to prove it is a bubble. … I’m not sure that the current situation is a classic bubble…”

    2. use your brain man, he is trying to hedge his bet by offering a conservative opinion, do you think he will go on TV talking about stock, housing and bond being overvalued if he really think they are only slightly over valued? Why would a famous economist warn about an asset being slightly overvalued?

  3. I should perhaps have labeled my first comment /sarc. And even if there was any validity to charting in the 50s, the sophisticated algorithms and highspeed computers of today have surely leveled any possible patterns down to zero.
    You mentioned that profits for many online firms depend on ad revenue, a good insight. Assume ALL newspaper and TV ad revenue is transferred to internet firms. How inflated would the stock values would be then?

    1. Socialbill,

      (1) The algo’s and their highspeed computers & comm lines are not using technical analysis in any normal sense. Their typical holding period is hundredths of a second. Most of it is just high-tech front-running of institutional orders and brokers’ sloppy market-making.

      (2) Based on what I read, I would guess that ad spending is more likely to shift from online than to online. Most versions of online don’t work well. The EBay experiment implied that Google search ads, which are supposedly among the highest-quality, are not worth much. Banner and display ads are cheap, but might not be worth even the low cost. The hated pop-up graphics and videos are IMO a waste of money. Ad blockers might wreck much of the online ad market.

      Just because it’s high tech doesn’t mean its good.

  4. Thanks for mentioning private sector debt. I guess the neoclassical narrative that private sector debt doesn’t matter because debt just moves money from savers to borrowers is losing traction. Much of this debt is created by banks by simply expanding their balance sheet. No savers required. If those same bank balance sheets threaten to shrink (again just like the GFC) by debt default look out below.

    The Fed FDIC chartered banks balance sheets are now in good shape here but shadow banks like our money market funds have unknown magnitude exposure to all kinds of counter parties. Glencore is in the spotlight now because they are big, they are leveraged, they are in trouble, and they are counterparty to a great number of commodity hedges.

    1. Peter,

      All sciences are reductionist, so we get the persistent problem of factors omitted from the models found to be significant. More precisely we get interactions proving significant of two factors each trivial by themselves. A male rabbit, a female rabbit – no problem. A male rabbit and a female rabbit = rabbit problem. That’s the problem with the current macroeconomic paradigm’s handling of private sector debt.

      As for the rest of your comment, it’s not accurate.

      “shadow banks like our money market funds have unknown magnitude exposure to all kinds of counter parties.”

      Money market funds are not “shadow banks” because they have no leverage. Also, there are no unknown exposures in money market funds. They are among the most regulated of securities. Unlikely to be a problem.

      “Glencore is in the spotlight now because they are big, they are leveraged, they are in trouble, and they are counterparty to a great number of commodity hedges”

      Commodity brokers often go broke. It’s not a systemic problem. They are tiny, even collectively, in macroeconomic terms.

    2. Peter,

      To understand the macroeconomic effect of high household debt loads, see a new NBER paper by Atif R. Mian, Amir Sufi, and Emil Verner: “Household Debt and Business Cycles Worldwide“. Abstract:

      A rise in the household debt to GDP ratio predicts lower output growth and higher unemployment over the medium-run, contrary to standard macroeconomic models. GDP forecasts by the IMF and OECD underestimate the importance of a rise in household debt to GDP, giving the change in household debt to GDP ratio of a country the ability to predict growth forecasting errors. We use lower credit spreads and increases in risky debt issuance as instruments for the rise in household debt to GDP to argue that our results are supportive of recent models where debt growth is driven by changes in credit supply, borrowing constraints, or risk premia.

      We also show that a rise in household debt to GDP is associated contemporaneously with a rising consumption share of output, a worsening of the current account balance, and a rise in the share of consumption goods within imports. This is followed by strong external adjustment when the economy slows as the current account reverses and net exports increase due to a sharp fall in imports. Finally, an increase in global household debt to GDP also predicts lower global output growth.

      The pre-2000 predicted relationship between global household debt changes and subsequent global growth matches closely the actual decline in global growth after 2007 given the large increase in household debt during the early to mid-2000s.

  5. Of course we’re going to listen. Stocks are going up, so it’s time to borrow on margin and buy more!
    Then, when the market implodes, we’ll blame our destitution on “bad luck.”

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