Historic Sentiment Extreme Suggests Stock Market Bubble on Verge of Collapse

| January 8, 2014

At a current duration of 58 months, the cyclical bull market in stocks that began in early 2009 is long overdue for termination and the character of market behavior during the last 12 months suggests that we are in the final, speculative blow-off phase of the rally.

Additionally, since early last year, stock market investment risk has remained in the highest one percentile of all historical observations. The latest speculative advance from October has increased risk to another historic extreme, joining a select group of four time periods that includes the long-term tops in 1929, 2000 and 2007.

According to the valuation components of the data used to calculate investment risk, the S&P 500 index is priced to produce an annual return of only 2.0 percent during the coming decade. Therefore, when you take into account the current dividend yield on the index, these highly reliable data suggest that stocks are poised to gain nothing in real terms during the next ten years. Granted, the market will likely go nowhere in an interesting fashion, but buy-and-hold investors who are entering the stock market at this level will almost certainly experience extremely poor performance during the next decade. Fueled by a historic amount of stimulus from the Federal Reserve, the cyclical bull market in stocks that began in 2009 continues to exhibit the characteristics of a classic bubble as defined by a log periodic advance.

As with all bubbles, it is impossible to predict when the inevitable collapse will occur with a meaningful degree of statistical confidence. However, extremely bullish investor sentiment during the last several weeks has caused our sentiment score to decline to the -100 level for the first time since early 1987. In October of that year, the stock market experienced one of the most memorable crashes of the past century. This extremely bearish reading suggests that the current bubble is on the verge of collapse.

Given the magnitude and duration of the developing stock market bubble, it is a virtual certainty that the next cyclical downtrend will be extremely violent and severe. If this bubble is followed by a typical post-bubble correction, the S&P 500 index will likely lose 30 to 50 percent during the forthcoming bear market. Of course, there will come a time when the risk/reward profile of stocks is once again favorable and the judicious study of market data will signal when that next long opportunity develops, just as it did in March 2009. However, now is a time for extreme caution and we remain fully defensive from an investment perspective.

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