What We’re Reading: Bubble Bath

by CC June 20, 2011 11:40 pm • Commentary


The S&P 500 finished the day up 0.54%. The index is now up 1.65% year-to-date but down 6.25% from the interim high set on April 29.

From an intermediate perspective, the index is 89.0% above the March 2009 closing low and 18.3% below the nominal all-time high of October 2007. Below are two charts of the index — with and without the 50 and 200-day moving averages.


For the second time since the bull market began, profits are surging and stocks are falling.

Standard & Poor’s 500 Index companies will earn 18 percent more this year than in 2010, according to the average estimate of more than 9,000 analysts compiled by Bloomberg. Higher profits haven’t stopped the gauge from falling 6.8 percent since April 29, pushing valuations to the cheapest levels in 26 years. Even if companies posted no growth, price-earnings ratios would be lower than on 96 percent of days in the past two decades.

The combination of China raising interest rates, concerns about a Greek default and the end of the Federal Reserve’s $600 billion stimulus program have almost wiped out this year’s gains. The divergence between profit forecasts and economic indicators shows the challenge to investors after the S&P 500 gained 88 percent from a 12-year low in March 2009.


Over the past few weeks, we’ve observed a fairly abrupt shift toward weakening across a variety of economic indicators, coupled with a deterioration in market internals. Investors have also placed a great deal of attention on the prospect for a default in Greek government debt. From our perspective, it is important to separate these issues. At least over the near term, the likelihood of a Greek default is quite small. The more pressing issue for investors is that market internals have deteriorated measurably, signaling a shift toward risk aversion among investors in an economy where the scope for further fiscal and monetary intervention is limited, and in a market that remains overvalued on the basis of measures that are actually well-correlated with subsequent market performance.

As usual, I have to emphasize the importance of using historically reliable valuation measures, as opposed to the common but wholly unreliable “forward operating earnings times arbitrary P/E” approach that is the mainstay of market commentators who seem to view historical research as optional. Based on a variety of historically reliable measures (detailed in numerous prior comments), we currently estimate that the S&P 500 is priced to achieve 10-year total returns averaging only about 4.1% annually, which (as a result of the recent market decline) is somewhat higher than the 3.4% we estimated several weeks ago, but remains unsatisfactory from the standpoint of investment merit.

I am not suggesting that the prospect of Greek default is unimportant, but based on the profile of Greek yields across the maturity curve, concerns about a near-term risk of Greek default appear premature. My impression is that a Greek debt default (and an exit from the European Monetary Union) is much more likely to occur in the final phase of the next bear market – not as the opening salvo. The bulk of investor attention at present should be placed on valuations, market internals, and economic factors.

The market is clearly oversold on a short-term basis (though only slightly on an intermediate-term basis). This has reached the point where some good news about Greece could prompt a relief rally, but the quality of market action in any advance will be important. We could see a bit of latitude to accept modest exposure on the basis of speculative merit, but that would require a shift toward more favorable internals, and it’s likely that any material advance would quickly reestablish an overvalued, overbought, overbullish, rising-yields syndrome. An improvement in market internals from lower levels would provide greater latitude for sustained exposure.

Despite the short-term oversold condition of the market, I should be clear that we are presently observing a combination of evidence that is typical of early bear markets – having some potential to be reversed, but with a generally dangerous record overall. This evidence includes the present combination of unfavorable valuations and unfavorable market action, developing concern from the most accurate version of our recession warning composite (which would be completed with a monthly S&P 500 close below about 1250 and another weak ISM report), a recent advance that has already passed the historical norms for extent and duration of cyclical bulls within secular bears (see Hanging Around, Hoping to Get Lucky ), and the neutral intermediate-term but hostile longer-term evidence we observed at the early May peak (see Extreme Conditions and Typical Outcomes ). All of this presently holds us to a generally defensive investment stance.


Despite the many obvious signs of slowing growth since the FOMC last met in April, we’re not expecting any bold new announcements from this meeting.

But if you’re looking for a preview, you could do worse than the latest analysis out of Credit Suisse:

• If Federal Reserve officials were hoping their $600bn large-scale asset purchase program (LSAP or ““QE2””) would glide tranquilly to its June 30 conclusion, they may be disappointed. Turbulence emanating from various sources threatens to complicate monetary policy navigation.

• But for now, the most likely scenario is that the Fed finishes its Treasury purchases as planned and then moves into an uncomfortable policy holding pattern for the balance of the year.

• Members of the Federal Open Market Committee will gather on June 21-22 amid a notable slowdown in domestic economic activity, resurgent concerns about the Eurozone periphery, and an impasse in government debt ceiling negotiations. The skies are also clouded by accelerating core inflation rates.

• Against this backdrop, Chairman Bernanke will conduct a press briefing following the committee’’s two-day meeting. We expect the tone of the FOMC policy statement and Bernanke’’s prepared text to resemble that of the chairman’’s June 7 speech in Atlanta on the US economic outlook.

• In that address, Bernanke acknowledged the weakness of the recent US economic data but suggested the soft patch will prove to be transitory. He also strongly implied that neither a new stimulus program nor a near-term tightening move is on the table.

• We anticipate the bottom line on June 22 will be similar and expect the FOMC to continue signaling ““exceptionally low levels for the federal funds rate for an extended period.”

Full report in the usual place.


With oil and gasoline prices tumbling, it seems an odd time for economists to be putting out notes about the growing risk of inflation, but two did just that today.

Barclays Capital and UBS have separate notes out today noting the recent rise in core inflation pressures, driven mainly by higher rent prices.

They suggest this recent increase in the core will push the Fed to act sooner than the market expects to tighten policy.

Here’s Barclays, led by Dean Maki:

Shelter costs, the only significant source of disinflation in the core CPI, continue to rise, pushing core inflation higher. Recent firming in the core CPI likely raises the bar for further action from the Fed.

By “further action,” he means QE3. Meanwhile, here’s UBS, led by Maury Harris, going a step further:

Market participants are pondering the relative importance of the recent soft patch versus the recent run-up in core inflation in the Fed’s thought process. We believe the Fed is currently more focused on the inflation half of its dual mandate. This view, coupled with our expectations of a rebound in second-half growth following the “soft patch”, continues to suggest the Fed will move earlier than the consensus expects—we look for the first increase in the Fed funds target rate in January 2012.

This is not at all what the fed-funds market expects. That market doesn’t expect the first rate increase until the second half of 2012.

And for good reason: Even UBS’s CPI forecast, just raised today, sees core CPI coming in at 1.9% in 2011 and 2.1% in 2012. This is not the stuff of runaway inflation.

The Fed has also said it will watch inflation expectations for cues on whether to flip the lever to tighter policy. There, inflation worries are fading.


Bonus: Why are We so Dumb?


Why are we so dumb? To better understand the source of our compulsive speculation, Read Montague, a neuroscientist now at Virginia Tech, has begun investigating the formation of bubbles from the perspective of the brain. He argues that the urge to speculate is rooted in our mental software. In particular, bubbles seem to depend on a unique human talent called “fictive learning,” which is the ability to learn from hypothetical scenarios and counterfactual questions. In other words, people don’t just learn from mistakes they’ve actually made, they’re able to learn from mistakes they might have made, if only they’d done something different.Unfortunately, fictive learning can also lead us astray, which is what happens during financial bubbles. Investors, after all, are constantly engaging in fictive learning, as they compare their actual returns against the returns that might have been, if only they’d sold their shares before the crash or bought Google stock when the company first went public. And so, in 2007, Montague began simulating stock bubbles in a brain scanner, as he attempted to decipher the neuroscience of irrational speculation. His experiment went like this: Each subject was given $100 and some basic information about the “current” state of the stock market. After choosing how much money to invest, the players watched nervously as their investments either rose or fell in value. The game continued for 20 rounds, and the subjects got to keep their earnings. One interesting twist was that instead of using random simulations of the stock market, Montague relied on distillations of data from famous historical markets. Montague had people “play” the Dow of 1929, the Nasdaq of 1998 and the S&P 500 of 1987, so the neural responses of investors reflected real-life bubbles and crashes.

Montague, et. al. immediately discovered a strong neural signal that drove many of the investment decisions. The signal was fictive learning. Take, for example, this situation. A player has decided to wager 10 percent of her total portfolio in the market, which is a rather small bet. Then, she watches as the market rises dramatically in value. At this point, the investor experiences a surge of regret, which is a side-effect of fictive learning. (We are thinking about how much richer we would be if only we’d invested more in the market.) This negative feeling is preceded by a swell of activity in the ventral caudate, a small area in the center of the cortex. Instead of enjoying our earnings, we are fixated on the profits we missed, which leads us to do something different the next time around. As a result investors in the experiment naturally adapted their investments to the ebb and flow of the market. When markets were booming, as in the Nasdaq bubble of the late 1990s, people perpetually increased their investments. In fact, many of Montague’s subjects eventually put all of their money into the rising market. They had become convinced that the bubble wasn’t a bubble. This boom would be different.

And then, just like that, the bubble burst. The Dow sinks, the Nasdaq collapses, the Nikkei implodes. At this point investors race to dump any assets that are declining in value, as their brain realizes that it made some very expensive mistakes. Our investing decisions are still being driven by regret, but now that feeling is telling us to sell. That’s when we get a financial panic.