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Echo Bubbles Abound

Pater Tenebrarum at Acting Man discusses Stock Market Manias of the Past vs the Echo Bubble.

The Big Picture

The diverging performance of major US stock market indexes which has been in place since the late January peak in DJIA and SPX has become even more extreme in recent months. In terms of duration and extent, it is one of the most pronounced such divergences in history. It also happens to be accompanied by weakening market internals, some of the most extreme sentiment and positioning readings ever seen and an ever more hostile monetary backdrop.

The above combination is consistent with a market close to a major peak – although one must always keep in mind that divergences can become even more pronounced – as was for instance demonstrated on occasion of the technology sector blow-off in late 1999 – 2000.

Along similar lines, extremes in valuations can persist for a very long time as well and reach previously unimaginable levels. The Nikkei of the late 1980s is a pertinent example for this. Incidentally, the current stock buyback craze is highly reminiscent of the 1980s Japanese financial engineering method known as keiretsu or zaibatsu, as it invites the very same rationalizations.

We recall vividly that it was argued in the 1980s that despite their obscene overvaluation, Japanese stocks could “never decline” because Japanese companies would prop up each other’s stocks. Today we often read or hear that overvalued US stocks cannot possibly decline because companies will keep propping up their own stocks with buybacks.

Of course, this propping up of stock prices occurs amid a rather concerning deterioration in median corporate balance sheet strength, as corporate debt has exploded into the blue yonder (just as it did in Japan in the late 1980s). The fact that an unprecedented number of companies is a single notch downgrade away from a junk rating should give sleepless nights to fixed income and stock market investors alike – as should the oncoming “wall of maturities”.

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A giant wall of junk bond maturities is looming in the not too distant future. Unless investors remain in a mood to refinance all comers, this threatens to provide us with a spot of “interesting times”. Something tells us that “QT” could turn into a bit of a party pooper as the “Great Wall” approaches.

It should also be mentioned that past stock market peaks, as a rule, coincided with record highs in buybacks. This indicates that record highs in buybacks are mainly a contrarian indicator rather than a datum providing comfort at extreme points.

Of course, what actually represents an “extreme point” can only ever be known with certainty in hindsight, as extremes tend to shift over time – particularly in a fiat money system in which the supply of money and credit can be expanded willy-nilly. What can be stated with certainty is only whether the markets are entering what we would call dangerous territory.

Buyback Explosion

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From an anecdotal evidence perspective the continued existence of curmudgeons like us who are aware of the above and are pointing out that this is a dangerously overstretched market may actually be a good reason to believe it will become even more overstretched. When the bubble pops one of these days, we may superficially look like the proverbial stopped clock that finally showed the right time – note though that our views on the big picture and our short-term tactics are two different cups of tea.

After all, we even trade cryptocurrencies, which are well beyond fundamental analysis – this is to say, we don’t believe it is possible to assign a “proper” valuation to them. We don’t know if a Bitcoin is worth nothing (that seems unlikely though) or a million dollars. What we do know is that it is a market that is extremely suitable for short-term trading based on technical analysis.

In terms of long-term investment strategies we prefer methods that eschew market timing altogether. We mainly rely on a specially adapted version of the permanent portfolio (which is extensively discussed in Austrian School for Investors, a book we modestly contributed to and warmly recommend, mainly for the contributions of the other authors).

Moreover, the “big picture” can only be judged once the cycle has fully run its course.

There are many additional charts and comments by Pater in the above link. Please take a look. Here is his final comment.

"The conclusion from all this is obviously that risk is currently very high. Of course, risk also spells opportunity, and anyone who has to have exposure to the stock market should at least consider hedging it while hedges can still be had for a song (which invariably is the case just before things go awry). "

Mike "Mish" Shedlock