Historic Stock Market Bubble Exhibits Signs of Weakness

| June 6, 2015

Context plays a vital role in the development of reliable market forecasts. Short-term price behavior only has meaning when analyzed in the proper context afforded by the long-term view, so all investing and trading strategies should begin with a thorough understanding of the current secular environment. There have been five secular trends in the stock market since the crash in 1929, three downtrends and two uptrends.

The current secular bear market began in 2000 following a speculative run-up during the second half of the 1990s. As usual, market behavior clearly signaled that a secular inflection point was approaching and our Secular Trend Score (STS), which analyzes a large basket of fundamental, internal, technical and sentiment data, issued a long-term sell signal in December 1999. At the time, our computer models predicted that stocks would enter a secular bear market that would last from 10 to 20 years. Following the topping process in 2000, a prototypical secular downtrend began that continues today.

The speculative advance that began in late 2011 has been driven primarily by unprecedented and direct intervention by the Federal Reserve. By holding short-term interest rates at effectively zero for the past six years, the Federal Reserve has punished saving and caused the massive inflation of speculative assets such as stocks.

When the quantitative easing program was initiated, then Chairman Ben Bernanke claimed that direct manipulation of the stock market would create a virtuous cycle that would somehow repair an economy that had become overburdened with excessive debt, even though no historical data supported this hypothesis. The following graph displays the impact of the quantitative easing programs as M1 money supply has more than doubled since 2008.

However, this stimulus has failed to register a meaningful positive impact as demonstrated by the facts that the M1 multiplier has remained below the key 1.0 level since 2008 and M1 velocity has plunged to the lowest level in 40 years.

As expected, these multiplier and velocity data indicate that the economy remains severely inhibited, weighed down by a massive mountain of debt. Research has clearly demonstrated that it is impossible to fix an excessive debt problem with additional debt, yet that is exactly what the Federal Reserve is attempting to do. The net impact of six years of negative real interest rates has been to create massive market distortions, including one of the three largest stock market bubbles of the past 90 years. Stock market investment risk remains at the highest level seen since 1929 and 2000, indicating that the current cyclical uptrend will almost certainly be followed by a decline of 40% to 60% during the forthcoming cyclical downtrend. Accordingly, the S&P 500 index is now priced to deliver a slightly negative return during the next ten years. By artificially manipulating the stock market, the Federal Reserve has essentially pulled future gains into the present and set the stage for a decade of extremely poor performance.

Due to their highly speculative nature, predicting the formation of bubble tops is extremely difficult to do with a useful degree of statistical confidence. Once the vast majority of market participants buy into the myth that is supporting the bubble in question, it takes a great deal of contrary evidence to shake their resolve. However, market data tell us when a bubble is weakening and becoming susceptible to a meaningful breakdown. For example, market internals such as breadth and volume have been negatively diverging from price behavior for the past year, and that divergence has begun to accelerate during the past two months.

The trends in market internal data such as breadth and volume tell us that distribution is taking place, suggesting that the bubble is losing strength. However, it is always important to remember that a long-term top is a process, not an event. Anything can happen over short-term time periods, but the key to having consistent success over the long run as an investor and a trader is to stay aligned with the most likely scenarios and protect yourself from the unlikely ones. 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 of historic risk and, therefore, a time for extreme caution, so we remain fully defensive from an investment perspective.

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