Bubble Talk Premature


Helped by optimism that politicians will engineer at least a temporary fix for Greece's debt troubles and that the U.S. Federal Reserve will be gradual in its interest-rate increases, the Dow Industrials and S&P 500 Index have moved within 2% of the all-time highs reached in mid-May.

The Dow Transports have bounced from a low reached on May 29 but remain more than 10% from the December all-time high of 9,217.44. A close above that level is necessary to reconfirm the bullish primary trend. But the Dow Theory is already in the bullish camp, and we continue to find reasonably valued growers. The stock-market exposure of our buy lists remains near 85%.

Bubble trouble?

Dow Theorists like to divide bull markets into three stages. In the first stage, stocks rebound as investor confidence rebounds from depressed levels. In the second, stocks advance with corporate earnings. In the third, stocks discount best-case scenarios as a speculative fever takes hold of investors.

The second stage often features the longest and most deceptive secondary corrections, and the transition from stage two to stage three is often mistaken for the beginning of a bear market.

So, does this year's extended trading range represent a transition to a speculative final run-up? That question is impossible to answer in advance, but a recent Credit Suisse report summarized by Barron's highlighted eight factors useful in recognizing an equity bubble. To paraphrase:

1) New paradigm talk emerges, with investors proclaiming this time is different.

2) Earnings become irrelevant.

3) Investors begin talking about the equity risk premium (the extra return stocks provide compared to bonds) going to zero.

4) Market breadth collapses, as fewer and fewer stocks lead the advance.

5) Buying becomes dominated by retail investors.

6) The number of mergers and acquisitions surges.

7) Earnings slump while per-share earnings rise.

8) Companies begin to overinvest, with high capital spending.

Of these eight factors, only No. 6 and No. 7 are happening now, and No. 7 mostly reflects the downturn in oil prices. In fact, today there is very little talk of a new era, and stocks continue to rise and fall with quarterly earnings. The equity risk premium is unusually high. Market breadth is decent, with advance-decline lines near recent peaks. Retail investors are mostly on the sidelines, judging from mutual fund inflows. And capital spending is restrained relative to sales.

Stocks are not cheap, but valuations are not at the extreme levels reached at bubble peaks. According to Credit Suisse, four of the last nine major U.S. bull-market peaks ended in bubbles. In all four, the S&P 500 Index's price/earnings ratio reached a level at least two standard deviations above the average of the previous 10 years. Today, the P/E is about one standard deviation above the 10-year average, according to Credit Suisse.

Our game plan

History suggests that timing the stock market with precision is difficult. History also suggests that even partly sidestepping a major, post-bubble bear market — like the more than 48% declines that ended in 1974 and 2009 — can be hugely impactful to your wealth.

Unless inflation and interest rates rise sharply, which is certainly possible, we tend to think any bear market from present levels is likely to be a garden-variety decline of 20% to 35%. With continued modest inflation and a resumption of earnings growth, the bull market's second stage could be extended for years. And if profits stall yet stocks advance on hopes and speculations, we're going to have a hard time finding reasonably valued growers.

For now, rather than make predictions, we're going to hold some extra cash and watch how things play out.

Current Hotline

Stock Spotlight

Individual Stock Reports

ISRs make stock research easy!

Perhaps the most valuable two page reports available anywhere.

All the data you would normally have to plow through years of 10-K filings, earnings reports, and reams of market data to assemble — yours all in one concise report.

ISRs contain our proprietary Quadrix scores — find out how we rate all the stocks in the S&P 500.

Visit us at individualstockreports.com