Michael Santoli

Are Stock Bulls Banking on a Bubbly Endgame?

Michael Santoli

It’s always dangerous to spin stories about exactly why markets are behaving as they are. And a major hazard of the past few years has been the instinct to point out financial bubbles that weren’t there.

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But, granting all that, sometimes writing about Wall Street means running toward danger — especially when a provocative narrative is also plausible.

So here goes: Breaking down recent market action and tracing optimists’ arguments to their logical conclusion, it seems the markets are hinting bubble-like conditions could emerge before too long.

The immediate, obvious prompt for this observation is the stock, bond and currency markets' rush to bid up risky bets the moment it was reported late Sunday that Lawrence Summers had pulled out of the running to succeed Federal Reserve Chairman Ben Bernanke.

Mis-impressions, major stock surges

Despite a thin evidence trail, investors had built up a mis-impression that Summers would be quicker to tighten monetary policy than the other frontrunner, Fed Vice Chair Janet Yellen. Once Summers withdrew, stock futures surged, the dollar sank and Treasury-bond yields dipped further from recent multi-year highs.

Now this quickly came to look like a reflex, emotional move, as stocks pared the early gains by Monday’s close, causing many chart readers to worry it proved a classic “sell on good news” culmination of the September rally toward the all-time index highs set in early August. This could prove the proper short-term interpretation. Chris Verrone, technical strategist at Strategas Group, noted the S&P 500 is up more than 4% in just 13 trading days and may be tiring, resulting in an "initially lazy challenge" of the early-August all-time high.

And a separate logical conclusion is that investors were mostly celebrating the diminished risk of a nasty, distracting confirmation fight, not a bubble-fest on the horizon.

Still, real “smart money” indicators showed the wisdom of the financial crowd genuinely downgraded the risk of a stiffer monetary stance emerging in coming years, as Neil Irwin of the Washington Post notes here.

So the immediate message of the Summers stand-down was that central bankers might let the financial party go on longer, that the risk of a Summers Fed being “less late” in cinching up interest rates was snuffed out.

A broader narrative

Yet, knitting together a broader narrative, markets seem tuned in to clues that perhaps this bull market – more than four years old with a 150% gain – can carry on almost as far and long as its storied, high-living predecessors of the 1980s and ‘90s.

The major commemorative narrative of the fifth Lehman Brothers failure anniversary has been that the financial system has healed, banks came through bigger and relatively unconstrained, the markets have massively outperformed the real economy. The cover of Time magazine, featuring the familiar lower-Manhattan bull statue in ‘80s-style shades and a party hat, declared “How Wall Street Won.” (This prompted the usual amateur contrarian analysis suggesting it foretells a market top, but the message was the tired line that the crisis "could happen all over again.")

Meantime, President Obama’s extolling of past years’ economic progress Monday marked a pivot away from blame-casting for the crisis to credit-claiming for the recovery. This is arguably a subtle but important shift in the economic storyline. It’s all the more noteworthy coming just weeks after Obama appeared to dig in his heels to back the unpopular Summers, while throwing rhetorical darts about “bubble-popping” regulatory efforts.

And the Twitter “soft” IPO filing – at a time when social-media stocks such as Facebook (FB) and some other momentum darlings such as Tesla (TSLA) are trading on world-conquering expectations – has kindled the blue-sky, easy-riches dreams that have been dormant for a long while.

Most market observers seem either to see bubbles everywhere or little chance of another. No, this is not a bubble. We're still in a neutral valuation/sentiment zone, with only a narrow slice of the market inflated by aggressive hopes. The indexes are up a ton since 2009, but only modestly from 13 years ago. While the average stock is far from cheap, it’s not so expensive that reasonable long-term owners are rushing to sell. The public is far from overexcited about stocks, and the IPO cycle remains nascent. Disciplined value investors profess a dearth of good buying opportunities, but others can readily tell themselves a plausible growth story to justify buying most stocks.

The Fed did a decent job of puncturing a building overconfidence baked into credit and stock markets in the spring by starting the "taper" clock on its stimulus program, preserving a layer of skepticism and anxiety.

But make no mistake: We’re in a pre-bubble state. Assets aren't cheap. Many making the case for stocks focus on financial engineering, hopes of accelerating corporate earnings from an already-elevated plateau and the "greater-fool" theory made explicit in the form of a supposed "great rotation" of money into stocks. The common argument for stocks is they are less pricey, and owned less avidly, than other comparable things the consensus insists are way overpriced.

Tony Dwyer, strategist at Canaccord Genuity, has defined the bullish extreme among market forecasters and has been right the past couple of years. He predicts the S&P 500 will rise 15% to 1,955 next year, then on to 2,400 by 2016. Part of his pitch is that the current run of increasing price-to-earnings multiples is "only about halfway" to the fattening of valuations of the '80s and '90s bull markets. Implicit in this is that stocks are on the way to frothy valuations that, years out, would make them unattractive and vulnerable to crash-like conditions.

Not every bull market ends in a bubble, and not all strong markets are bubbles in the making. This one has some sturdy underpinnings, with corporate profits at record levels. As the year started amid fears of a growth slowdown and government-spending cuts, bond-like dividend stocks carried the indexes higher. As emerging-markets hit the skids, the domestic housing-led recovery story let small consumer and bank stocks lead. Now that Europe is healing and emerging countries stabilizing, multinational industrial blue chips are taking the fore.

The bullish outlook retains the benefit of the doubt and there are still enough skeptics to continue feeding on for some time.

Still, anyone expressing a seriously bullish view is implicitly suggesting it culminates in prices for risky assets that will prove excessive and unfavorable for long-term investors over the ensuing cycle. The financial market recovery has been so much stronger and faster than that of the labor and industrial economy that, if the Fed seeks to prolong its easy-money policies, it would almost certainly fuel further financial-market gains and increasingly tough-to-rationalize valuations.

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