Technical Indicators Point to a Post COVID-19 Stock Market Bubble
Technical indicators and macroeconomic factors are pointing to the formation of a tech driven market bubble precipitated by a large sell-off after the November elections. I would argue that recent market highs are unsustainable and that we are entering the “post-COVID-19 bubble”.
The U.S. stock market has not truly priced in the effects of COVID-19 and the political uncertainty of upcoming elections. And while governments have done well to weather this pandemic by pumping trillions of dollars to support the debt and equity markets, this will prove ephemeral.
The S&P 500 and Nasdaq hit all time highs, but is this irrational exuberance? True unemployment is still around 15%. Government lockdowns and reduced consumer and corporate spending will shave at least 45% off of earnings in Q2. Large segments of the economy that include retail, restaurants, entertainment and leisure have been devastated and are relying on government assistance to avoid bankruptcies.
Even if a vaccine is found, I would argue that the recovery in these sectors in 2021 will be slow coming.
Meanwhile, prime interest rates are at zero and corporate debt is ballooning. Although the Fed is buying up corporate debt at a rapid clip to shore up the bond markets, the net result is printing large amounts of money, inflation, and devaluation of the U.S. Dollar. Equities generally don’t like a devalued dollar because it reduces purchasing power. That’s why gold is symmetrically on the rise.
If the markets had priced all of this in, then a market correction would be unlikely. The flight of capital into equities like Amazon, Google, Apple, Microsoft, as well as the the ecosystem that supports the “stay-at-home” economy has lifted the markets to new highs.
And while weighted allocations and some speculation in tech stocks would not normally be a problem, this seems to be the only game in town. Millennial Robinhood investment trends have created mini bubbles in stocks like Tesla and Beyond Meat.
And traditional safe-havens such as treasuries and AAA debt are yielding next to nothing if you count total returns. Energy stocks are also depressed.
To me this, indicates that market participants are buying growth stocks, not because all tech companies are growing revenue and earnings at pace, but rather because bonds and traditional dividend paying value stocks are yielding poorly.
Below, I provide a technical analysis of how a combination of key macro and micro economic factors is converging towards a likely market crash near the end of this year.
The Schiller P/E ratio compares S&P 500 stock prices to inflation adjusted earnings over the past 10 years. It is referred to as the Cyclically Adjusted Price to Earnings Ratio (CAPE). A high CAPE ratio has been linked to the phrase “irrational exuberance” and to Shiller’s book of the same name. After Fed President Alan Greenspan coined the term in 1996, the CAPE ratio reached an all-time high during the 2000 dot-com bubble. It also reached a historically high level again during the housing bubble up to 2007 before the crash of the great recession. The current Schiller P/E ratio indicates that stocks are in an “extreme bubble”.
The Wilshire 5000 Index is widely accepted as the definitive benchmark for the U.S. equity market and is intended to measure the total market capitalization of most publicly traded companies headquartered in the United States. Market Cap to GDP is a long-term valuation indicator for stocks. It has become popular in recent years, thanks to Warren Buffett. Back in 2001 he remarked in a Fortune Magazine interview that “it is probably the best single measure of where valuations stand at any given moment.”
As shown over a 50-yr. period, the mean (average) Wilshire 5000 market cap to GDP ratio has been .8, although over the last 20 years the mean has been considerably higher. In 2020, we are now almost .6 above this ratio without a meaningful correction towards the mean. If past crashes are indicative of future corrections, I would argue that this ratio will see a meaningful move towards the mean by the end of the year.
The infamous yield curve spread, that is a difference between long term treasury yields and short term treasury yields, is a reliable indicator of recessions. A negative spread indicates an inverted yield curve. The curve for comparing 10yr to 1-yr. treasuries inverted at the end of 2019. In such a scenario short-term interest rates are higher than long-term rates, which is often considered to be a predictor of an economic recession. Past recessions have followed on average 18 months after yield curves inverted. We are hitting the 12 month period after the yield curve for the 10 yr and 1yr. treasuries inverted in August 2019. Therefore, be on the lookout for another major correction in the next 3–6 months.
In order to allow for comparison over time, a nation’s debt is often expressed as a ratio to its gross domestic product (GDP). Corporate debt includes bank loans and corporate bonds that were issued to raise money for goods and services. The GDP is a good indicator of economic output and health of a nation’s goods and services. Historically, the ratio has increased during wars and recessions. Over the last 10 years, low interest rates have fed corporate borrowing, vastly increasing corporate debt. Historically, when the debt to GDP ratio hits 45%, a recession follows. We are well above this 45% threshold, which indicates a market crash is imminent.
The “M2 Money Supply”, also referred to as “M2 Money Stock”, is a measure for the amount of currency in circulation. M2 includes M1 (physical cash and checkable deposits) as well as “less liquid money”, such as saving bank accounts. Money supply growth and inflation are inexorably linked. The chart above plots the yearly change in M2 and the Inflation Rate, which is defined as the yearly change in the Consumer Price Index (CPI). When inflation is high, prices for goods and services rise and thus the purchasing power per unit of currency decreases. Historically, M2 has grown along with the economy. The dot.com bubble burst in 2001 and the mortgage crisis market crash followed when the money supply and inflation rate spread hit 10%. The M2 to inflation rate spread is now well over 20%. This means, inflation has yet to catch up with the money supply and a correction is likely as inflation ticks up.
Conclusion
The current stock market rally is not sustainable. Valuations of companies that have yet to report their worst earnings quarter since the 2008 financial crisis are stretched, and corporate debt levels are rising much faster than GDP. While governments have pumped trillions of dollars into the economy to keep it afloat and prevent a run on the credit markets, inflation is sure to tick up rapidly as the money supply is rising too fast. Couple this with a recently inverted yield curve, and you have a recipe for unhealthy debt and equity markets. Even if COVID-19 is under control by the end of this year, the majority of current stock prices do not reflect the true state of the economy or even future earnings. Finally, the prospects of a Trump reelection are dimming, and with a Republican leaving the executive branch, traders will sell out of the market as fears of higher taxes, regulations and political uncertainty sets in.
