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Irrational Exuberance? Not Yet, but Working Our Way Toward It


We are not yet at a stock market top, but be leery at these levels.

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade.
Alan Greenspan, December 5, 1996

We're in the late innings of a bear market rally fueled by massive fiscal and monetary stimulus designed to lure investors back into stocks, convincing them the worst is in the rearview mirror. But there will be a bitter price to pay for spending and greasing the wheels of global growth -- investors can expect rising interest rates, hyperinflation, and a potential run on the dollar. Hence the current fondness for gold. (See: I Shorted the United States Treasury Market -- And You Should, Too.) A corrective measure for the debt-fueled binge of the past decade would be a great cleansing of the economy and the markets, and that's not something politicians (especially those facing reelection) want when the ballots are passed around.

The definition of a revolution: It destroys the perfect and enables the impossible. Our country and its global counterparts are in need of an economic and systematically structured revamping. One that we can look back upon in time and point to as the beginning of a legacy founded on leadership that brought prosperity and promise.

The midterm economic picture remains murky, and a muddle-through approach won't maneuver our markets higher for much longer. With the prospect of a recovery in domestic economic numbers, job creation, and GDP growth, it's paramount that we not kid ourselves about what it will take to survive if Uncle Sam fumbles and the economy begins to stumble down a slippery slope of confusion and foreign contagion.

China's trade deficit recently climbed to 1989 lows on the back of slowing demand. Reduced copper and iron ore purchases and rising commodity costs also point to slowing growth, and China recently paid a record price for February crude supplies. Slowing GDP growth and rate cuts occurring in key growth-driving BRIC nations is a significant concern outside of European debt contagion.

The ending in Greece was scripted, the actors performed their parts, and the result was an "orderly default." The Greek people could have stopped the deal-making, but they rolled over. Probably the same scenario, if needed, will play out for Portugal, Ireland, or Spain. Funny how the fear of a sovereign debt default took the US stock market down 20%, not once but twice, and our markets hold firm on the actual event.

Are investors reacting to Greece the same way they reacted to the Bear Stearns take-under? Recall the stock market cracked on Bear's internal concerns, but it did not crater. The market was able to find its footing and put in a near-term floor as Bear's fate was finally known, an event that was largely priced into the market. What many distracted investors were not able to ask of the markets at that time was: What are we missing, and what are our eyes not focusing on?

The possibility of social unrest -- with social moods tilting towrd acrimony, something we deemed inconceivable in a civilized society -- should now be a mainstay within our minds. The sight of citizens revolting against governments at a mass level, which we didn't think was possible in the modern world, has become a nightly news highlight. Around the world, city streets burn, fueled by hatred and a need for vengeance. Are we finally at a point in history where there are too many players in the world with different objectives? The past has always been communism/dictator vs. democracy, at least in the 1900s.

What could make its way to the surface? What are we not seeing that could toss the world markets into chaos? Is the next event resource-driven (oil) or capital-driven (banking)? The only events I imagine having the importance to wreck economies would involve Syria, Iran, and Israel. Will Iran wage war by holding crude oil hostage through shunning exports to certain regions of the world and disrupting supply delivery in the Middle East?

On Friday, the S&P 500 opened and closed above the top of its Bollinger band for just the fifth time since the beginning of 2000. The last two readings occurred in July 2011 and November 2010. This is interesting to me as I have been calling the recent market pause something that resembles the June/July 2009 corrective action and that of November 2010. In both instances the market worked off overbought conditions through time rather than price, ultimately confusing to the crowd. Before that, late September 2007 and March 2000 are dates that should be firmly implanted in our memories.

Consensus EPS growth forecasts are lofty at 9% in 2012 and 13% for 2013, and corporate profit margins are at a record high. Is it wise to place your bets on a market lacking large bets? Or do foreign inflows flock to the US stock market, which is seen as a safe haven? The Shiller P/E index is sitting at a level that does not translate to value at 22 times earnings. Historically this reading tops out in the mid 20s; it is not running at an extreme reading.

Be mindful that valuation has trailed the five-decade average of 16.4x for the longest stretch since the 13-year period beginning in 1973, according to Bloomberg data, but it is not significantly lagging where one would uncover value. Recall Barron's mid-2009 bearish cover story on commercial real estate that would send the SPX to 400. We now have consecutive months with bullish calls on the stock market and residential housing on Barron's cover canvas.

As I comb through current market sentiment, historical complexions, and global macro movement, it appears to me that the dust has not settled on this 12-year run of consolidation for equity markets. Value is not present in the current market, and for investors looking to initiate, a defensive posture is preferred. The next resistance level in the market will be found in the 1420-1440 region, with 1370 and 1350 transforming into future support from past resistance. To get to all-time highs, there will need to be a multiple expansion. There isn't a clear catalyst to push multiple expansion. Maybe it's just exuberance.
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