Has the Stock Market Bubble Burst?

| February 9, 2014

For the past four years, the stock market has exhibited the classic characteristics of a bubble as defined by a log periodic advance. Fueled by a historic amount of stimulus from the Federal Reserve, the cyclical bull market from 2009 has accelerated into an unsustainable advance and the next long-term top will almost certainly be followed by a violent correction that will result in substantial losses. In early January, we noted that the historic extreme in bullish sentiment suggested that the bubble was on the verge of collapse. Since then, the S&P 500 index has moved sharply lower, indicating that the top of the bubble may be in the process of forming.

However, as we often note, a cyclical top is a process, not an event. The recent breakdown of the power uptrend from 2012 is the first sign of a long-term reversal, but market behavior during the next several weeks will determine if the next cyclical bear market is commencing.

The latest intermediate-term cycle low (ITCL) is imminent and it could form at any time. How the stock market behaves following the confirmed formation of the latest ITCL will tell us if a long-term top is likely developing.

From a short-term perspective, the magnitude of the beta phase decline of the cycle from December signaled the likely transition to a bearish translation. Our computer models identified the potential formation of the latest short-term cycle low (STCL) last week and the cycle low signal that was generated on Thursday confirmed that a new cycle is in progress. If the formation of the latest ITCL is confirmed by subsequent market behavior during the next two weeks, the character of the developing short-term cycle will provide the next assessment of cyclical bull market health.

Regardless of whether the next cyclical top is forming right now, it is critical to maintain focus on the long-term view. The bull market from 2009 is long overdue for termination and market investment risk remains at an extremely high level.

As with all bubbles, it is impossible to predict when the inevitable collapse will occur with a meaningful degree of statistical confidence. However, recent developments suggest that a long-term reversal could be in progress right now, so it will be important to monitor market behavior carefully during the next several weeks. 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. Therefore, now remains a time for extreme caution and we remain fully defensive from an investment perspective.

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