Bull Markets & Irrational Exuberance

Bob Doll from Nuveen Investments is more bullish on stocks than I am but sets out his thoughts on what could cause the current run to end:

“Stock valuations are starting to look full, and technical factors are beginning to appear stretched. As stock prices have risen since last summer, bond yields have crept higher. Should this trend persist, it could eventually cause a headwind for stocks. Credit spreads are signaling some risks, as non-energy high yield corporate bond spreads have dropped to multi-decade lows.

As such, we think stocks may be due for a near-term correction or consolidation phase. Nevertheless, we expect any such phase to be mild and brief as long as monetary conditions remain accommodative and economic and earnings growth holds up. In other words, although we see some near-term risks, we don’t think this current bull market is ending.

That raises the question of what might eventually cause the current cycle to end. We see three possibilities. First, recession prospects could increase significantly. We see little chance of that happening any time soon, given solid economic fundamentals. Second, a political disruption like a resurgence in trade protectionism could occur. We also don’t think that is likely to happen, especially in an election year. Third, bond yields and interest rates could move higher as economic conditions improve, creating problems for stocks. This one seems like a higher probability, and we’ll keep an eye on it.”


The upsurge in retail sales and housing starts may have strengthened Bob’s view of the economy but manufacturing is in a slump and slowing employment growth could hurt consumption. The inverted yield curve is a long-term indicator and I don’t yet see any indicators confirming an imminent collapse.

Treasury 10 Year-3 Month Yield Differential

I rate economic risk as medium at present.

Political Disruption

US-China trade risks have eased but I continue to rate political disruption as a risk. This could come from any of a number of sources. US-Iran is not over, the Iranians are simply biding their time. Putin’s attempted constitutional coup in Russia. China-Taiwan. Libya. North Korea. Brexit is not yet over. Huawei and 5G are likely to disrupt relations between China, the US and European allies, with China threatening German automakers. Europe also continues to wrestle with fallout from the euro monetary union, a system that is likely to eventually fail despite widespread political support. Impeachment of Trump may not succeed because of the Republican majority in the senate but could produce even more erratic behavior with an eye on the upcoming election. Who can we bomb next to win more votes?

Bonds & Interest Rates

I don’t see inflation as a major threat — oil prices are low and wages growth is slowing — and the Fed is unlikely to raise interest rates ahead of the November election. Bond yields may rise if China buys less Treasuries, allowing the Yuan to strengthen against the Dollar, but the Fed is likely to plug any hole in demand by further expanding its balance sheet.

Market Risk: Irrational Exuberance

The market is running on more stimulants than a Russian weight-lifter. Unemployment is near record lows but Treasury is still running trillion dollar deficits.

Federal Deficit & Unemployment

While the Fed is cutting interest rates.

Fed Funds Rate & Unemployment

And again expanding its balance sheet. More than twelve years after the GFC. The blue line reflects total assets on the Fed’s balance sheet, mainly Treasuries and MBS, while the orange line (right-hand scale) shows how shrinking excess reserves on deposit at the Fed have helped to create a $2 trillion surge in liquidity in financial markets since 2009. Even when the Fed was supposedly tightening, with a shrinking balance sheet, in 2018 to 2019.

Fed Totals Assets & Net of Excess Reserves on Deposit

The triple boost has lifted stock valuations to precarious highs. The chart below compares stock market capitalization to profits after tax over the past 60 years.

Market Cap/Profits After Tax

Ratios above 15 flag that stocks are over-priced and likely to correct. Peaks in 1987 and 2007, shortly before the GFC, are typical of an over-heated market. The Dotcom bubble reflected “irrational exuberance” — a phrase coined by then Fed Chairman Alan Greenspan — and I believe we are entering a second such era.

Recovery of the economy under President Trump is no economic miracle, it is simply the triumph of monetary and fiscal stimulus over rational judgement. Trump knows that he has to keep the party going until November to win the upcoming election, so expect further excess. Whether he succeeds or not is unsure but one thing is certain: the longer the party goes on, the bigger the hangover.

William McChesney Martin Jr., the longest-serving Fed Chairman (1951 to 1970), famously described the role of the Fed as “to take away the punch bowl just as the party gets going.” Unfortunately Jerome Powell seems to have been sufficiently cowed by Trump’s threats (to replace him) and failed to follow that precedent. We are all likely to suffer the consequences.

It’s a bull market

Dow Jones Industrial Average successfully tested the new support level at 18000 and has now broken resistance at 19000, confirming the target of 20000*. Rising Twiggs Money Flow indicates selling pressure has ended. Expect a brief retracement to test support at 19000 but respect is likely.

Dow Jones Industrial Average

* Target medium-term: 18000 + ( 18000 – 16000 ) = 20000

Charles Dow, founder of Dow Theory more than a century ago, always waited for confirmation from the Rail Average. Nowadays, railways have diminished in importance and we use the broader Transport Average which currently signals a primary up-trend after a lengthy “line” or narrow consolidation over the last 3 months.

Dow Jones Transport Average

It is also advisable to look for confirmation from the broader S&P 500 and the tech-heavy Nasdaq 100 index.

The S&P 500 broke resistance at 2200, signaling a primary advance with a target of 2300*. Rising Twiggs Money Flow again indicates that selling pressure has ended.

S&P 500 Index

* Target medium-term: 2200 + ( 2200 – 2100 ) = 2300

The Nasdaq 100 recently set an all-time high after breaking resistance at its March 2000 high of 4700. Retracement twice respected the new support level and follow-through above 4900 would confirm another primary advance.

Nasdaq 100

How Market Tops Get Made | Bloomberg

Barry Ritholz interviews Paul Desmond, chief strategist and president of Lowry’s Research:

According to Lowry’s, “the weight of evidence continues to suggest a healthy primary uptrend with no end in sight.”

….. based on the data Desmond follows, he makes a fairly convincing case that this bull market still has a ways to go before it tops out.

Read more at How Market Tops Get Made – Bloomberg View.

Visible Hand Of The Fed | Business Insider

Lance Roberts writes:

While the Fed programs that we have witnessed since the financial crisis are historically unique — liquidity driven markets are not. We have witnessed the effects of excess liquidity in the bull market cycle prior to the 2008 financial crisis. The only difference during that cycle was that, through government intervention, real estate was turned into an ATM allowing mortgage equity withdrawals to be the liquidity source for the economy and the markets…….

Read more at Lance Roberts: Visible Hand Of The Fed – Business Insider.

One down five to go

I say this rather flippantly as we are in the middle of a bear market, and I do not believe we are ready, but a reader asked what it would take to signal a bull market. My answer: three decent blue candles on the weekly chart followed by a correction of at least two red candles that respects the preceding low. The weekly chart of the S&P 500 index displays a blue candle with a long tail, signaling buying support. That would qualify as candle #1.

S&P 500 Index

* Target calculation: 1100 – ( 1250 – 1100 ) = 950

There is no supporting divergence on 13-week Twiggs Money Flow to signal a change in the underlying selling pressure. Reversal to an up-trend is unlikely but would take a rally of at least 3 blue candles to break resistance at 1250 followed by a correction that finishes above 1100 — and re-crosses 1250. What is more likely is a failed attempt or false break at 1250 followed by penetration of support at 1100, signaling a decline to 1000/950*.