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

Larry Kummer, Editor

11 years ago

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.

(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.

(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.

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.

(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).

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.

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).