MorningWord 2/18/15: The Bubbles Within

by Dan February 18, 2015 9:29 am • Commentary

Bubble is a term that market pundits just can’t help themselves from saying whenever markets make new all time highs.  A year ago, when the S&P 500 was at a new all time (14% lower than now) the financial media was scrambling to find bubbles. At the time there were pockets of mini-bubbles like 3D printing stocks and some internet services (that have since popped), but in general most sectors traded within widely accepted valuation bands. And despite those little pops, the overall market is higher.

Whether or not current equity valuations are warranted on traditional merits like earnings and sales growth, current valuations owe a lot to the unprecedented period of historically low interest rates. This financial engineering has served in place of an expansion of r&d, capex and hiring. The plan has always been to hand the economy back to the companies when they are ready to pick up the baton. But at some point it became clear that it was just easier to continue to ride the wave, and not risk the consequences of a round of tightening. Regardless of the reasons, most major U.S. equities are at new highs (or threatening) and most of the stocks and sectors that have done a lot of the heavy lifting, trade at or slightly above market multiples.

What’s fairly clear to me is that despite equities getting most of the headlines (until recently), the bubbles that have been inflated from ZIRP have been in U.S. Treasuries, high yielding bond proxies (utilities and staples) and of course commodities. Of those three, Treasuries show the best relative strength given their safe haven asset status, while expensive equities that investors flocked to for yield should fair the worst if our economy continues to improves. And then there’s commodities. Your guess is as good as mine, and it has less to do with the health of our recovery than that of the rest of the world.  But make no mistake, free money caused lots of demand for commodities where they were building empty cities in China. I obviously have no idea how this shakes out, but if you are looking for an equity bubble in large cap U.S. stocks, then I would suggest it has yet to inflate (and if rates stay low, still could).

Above I mentioned sectors like 3D printing a great example of a bubble inside a bull market.  Look no further than 3d Systems (DDD) which commanded a greater than $10 billion market cap in early 2014, trading at 20x sales on the promise of a massive secular trend in manufacturing.  The promise still exists a year later, but the stock is down 65% from the all time highs. The bubble has burst, and the sector and related stocks are for the most part excluded from every day discourse on the markets:

DDD 4 year chart from Bloomberg
DDD 4 year chart from Bloomberg

Of course, with massive short interest like DDD’s 35%, deflated bubbles have the potential to overshoot on the downside and have sharp reversals higher, just as they once did on the upside. So there’s still trading opportunities after the bubble pops.

It is a perfectly reasonable strategy to look for the bubbles within. There were tremendous opportunities to make money on the short side within what has been a raging bull market over the last few years.  Have a ball and stay long U.S. stocks that are not a bubble (yet) but be cognizant of the fact that there are mini bubbles inflating and popping within the bull market and there are plenty of trading opportunities from the short side to add alpha to your portfolio in what has been a hard market to do anything other than stay long the SPX.