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Could Stocks Melt Up?

  • Written by Syndicated Publisher No Comments Comments
    June 20, 2014

    Over the weekend, E.S. Browning wrote a very interesting article for The Wall Street Journal entitled: “Blast From The Past: Could Stocks Melt Up?”

    “Money managers and analysts are beginning to talk about an idea that dates from the roaring ’90s: a rapid stock gain known as a melt-up.”

    The reason that this is interesting is because it is something that we have witnessed many times in the past.  Each time, as it was occurring, the always bullishly biased Wall Street community dismissed the unhealthy rise as “this time was different.”  To wit:

    “In the late ’90s, people thought a melt-up, or a sudden double-digit percentage rise, was a fine thing. Set off by some exciting event, melt-ups feed on their own gains as people rush to avoid missing out.”

    The chart below shows the nominal price history of the S&P 500 from 1900 to present overlaid with the historical trailing price-to-earnings ratio.

    SP500-PE-Peaks-061614

    I have highlighted key periods in market history where the fateful words, or variations thereof, “this time is different” were uttered.  Last week, I posted the following in relation to the excessive push by investors into the riskiest levels of credit in the ongoing “chase for yield.”

    “We have seen this exuberance before.  In 1999, the old valuation metrics no longer mattered as it was “clicks per page.”  In 2007, there was NO concern over subprime mortgages as the housing boom fostered a new era of financial stability.  Today, it is the Federal Reserve ‘put’ that is unanimously believed to be the backstop to any potential shock that may occur.”

    Bond-Yields-JunkBonds-SP500-061214

    Melt-ups have always eventually led to meltdowns. During the “melt up phase,” the short term emotional forces of greed and exuberance overwhelms the long term investing sensibilities of logic and discipline.  This is particularly interesting since investors are supposed to be investing for the “long term.”

    Mr. Browning’s article is interesting because it is something that I discussed at length earlier this year in “The Coming Market Meltup.”

    In that missive, I covered some of the drivers that are likely to push asset prices higher through the end of 2015 as the Mid-Term Election cycle collides with the Decennial market cycle.  To wit:

    “However, looking ahead to 2015 is where things get interesting.  The decennial pattern is certainly suggesting that we take advantage of any major correction in 2014 to do some buying ahead of 2015.  As shown in the chart above, there is a very high probability (83%) that the 5th year of the decade will be positive with an average historical return of 21.47%.

    The return of the positive years is also quite amazing with 10 out of the 15 positive 5th years (66%) rising 20% or more.  However, 2015 will also likely mark the peak of the cyclical bull market as economic tailwinds fade, and the reality of an excessively stretched valuation and price metrics become a major issue.

    As you will notice, returns in the 6th and 7th years (2016-17) become substantially worse with a potential of negative return years rising.  The chart below shows the win/loss ratio of each year of the decennial cycle.”

    Decennial-cycle-011414-2

    It was in 1996 that Alan Greenspan first uttered the words “irrational exuberance” but it was four more years before the “bull mania” was completed.  The “mania” of crowds can last far longer than logic would dictate and especially when that mania is supported by artificial supports.

    There are plenty of reasons that that the market could lapse into a far bigger correction sooner than the historical evidence would otherwise suggest.  Such an event would not be the first time that an “anomaly” in the data has occurred.

    The inherent problem with much of the mainstream analysis is that it assumes everything remains status quo. The reality is that some unexpected exogenous shock is likely to come along that causes a more severe reversion as current extensions become ever more extreme.  This though was eloquently stated by Jeremy Grantham:

    My personal guess is that the U.S. market, especially the non-blue chips, will work its way higher, perhaps by 20% to 30% in the next year or, more likely, two years, with the rest of the world including emerging market equities covering even more ground in at least a partial catch-up. And then we will have the third in the series of serious market busts since 1999 and presumably Greenspan, Bernanke, Yellen, et al. will rest happy, for surely they must expect something like this outcome given their experience.  And we the people, of course, will get what we deserve.

    What can go wrong for the market? In a word, “much.” Economic growth remains very elusive, corporate profits appear to have peaked and there is an overwhelming complacency with regards to risk. Those ingredients combined with an extraction of liquidity by the Federal Reserve leaves the markets more vulnerable to an exogenous event than currently believed.

    I agree with Mr. Grahtham. It is likely that in a world where there is virtually “no fear” of a market correction, an overwhelming sense of “urgency” to be invested and a continual drone of “bullish chatter;” markets are poised to “melt up” before the eventual reversion occurs.

    Mr. Browning summed it up well by stating:

    “Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch, is warning clients that the market could see ‘an unhealthy, speculative increase in asset prices,’ which would leave stocks and bonds both vulnerable to sharp declines.

    ‘If you get a melt-up, it is going to take the market into overvalued territory,’ Mr. Hartnett said. A negative surprise on economic growth, corporate earnings, Federal Reserve interest-rate policy or something else then could send stocks sharply down, he said.

    Of course, such events rarely happen when people are worried about them. It is when people forget their concerns and go for broke that markets get in trouble.”

    This “time IS different” only from the standpoint that the variables are not exactly the same as they have been previously. Of course, they never are and the result will be“…the same as it ever was.”


    Talking Heads – Once In A Lifetime

     

    Lance Roberts is the General Partner and Chief Portfolio Strategist for STA Wealth Management. He is also the host of “The Lance Roberts Show,” Chief editor of the X-Factor Investment Newsletter and the Streettalklive daily blog. Follow Lance on FacebookTwitter and Linked-In

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of StreetTalk Live

    After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.

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