Last week, the ongoing “can’t stop, won’t stop” bullish trend remained firmly intact. As we noted then:

“That remains the case this past week. While the overall market traded higher into the end of the week, setting new all-time highs, the bullish November trend remains intact. While the market remains confined to that narrow rising trend channel, the MACD “buy signal” remains elevated, and an apparent deterioration in the market’s momentum remains.”

That was the case again this week, as the market tested the 20-DMA, the bottom of the trend channel, early in the week, which sparked buyers to push the index to all-time highs by the week’s end. At the same time, volatility remains compressed, with the deviation from the 200-DMA growing. As shown, the breadth of the market and momentum are both negatively diverging from the rising market, which historically serves as a warning.

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While we have become increasingly cautious over the last few weeks, as the market continues to rise, we have suggested taking profits and rebalancing portfolio risks. If you have not done so, such remains a recommended course of action. However, this does not mean to reduce equity allocations aggressively.

As noted, the market remains in a bullish trend. The 20-DMA, the bottom of the trend channel, will likely serve as an initial warning sign to reduce risk when it is violated. That level has repeatedly seen “buying programs” kick in and suggests that breaking that support will cause the algos to start selling. Such a switch in market dynamics would likely lead to a 5-10% correction over a few months. We will reduce equity positioning and aggressively implement hedging strategies at that point.

However, the question we have been asked most this week is, “Are we in a market bubble?”

 

 

Market Top Or Is It A Bubble?

The run in Artificial Intelligence (A.I.) stocks this year has many analysts making comparisons to the 1999 “Dot.com” bubble. As shown in the chart below, there are some reasons for that concern. In 1999, Cisco Systems (CSCO) was the “belle of the ball,” and the “internet would change the world.” The thinking at that time was that the whole internet would run on Cisco routers at 50% gross margins. Today, Nvidia (NVDA) has 75% gross margins and 75% market share. Just as in 1999, extrapolated valuations rarely play out in reality.

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As discussed recently, the valuations investors currently pay for companies like Nvidia (35x Price-to-Sales) are also unsustainable. As shown in the chart from TheMarketEar below, when 33x sales were Cisco’s valuation at its peak of the “Dot.com” mania, investors lost 85% of their money when the stock price troughed in October 2002. Over the next 16 years, as investors waited to break even, the company grew revenues by 172% and earnings per share by a staggering 681%

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Furthermore, there is certainly some concern given the valuations of the “Magnificient 7” versus the rest of the market.

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Notably, this is FORWARD valuations, which assumes that the “Magnificent 7” will obtain rather lofty earnings growth rates in the future versus relatively low expectations for the rest of the market. The problem is that Wall Street analysts, particularly at market extremes, are always wrong concerning their estimates.

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Therefore, the risk is that analysts expect continued strong earnings growth for the S&P 500, which is entirely based on the “Magnificant 7.” Of course, if the economy slows more than expected, those expected earnings are much too high.

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Notably, the valuations of the growth sector of the market are trading at astronomical levels relative to its 10-year average.

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So, are we currently in a “bubble,” or is this just a potential short-term market top?

 

Probably Not A Bubble…Yet

As noted, there are certainly concerns about the market. One of those concerns is the concentration of market capitalization within the index. Historically, such concentrations did not lead to the most bullish of outcom

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However, there are several differences between today’s stock market rally and the “Dot.com” bubble. First, in 1999, many of the companies that were trading at astronomical heights had no earnings, little revenue, and, in many cases, were running up on “made up” metrics like “eyeballs” and “clicks” per page. Today, that story is quite different, with companies like Microsoft, Google, Amazon, Nvidia, AMD, and the rest generating billions in revenue, strong earnings growth, and fundamentally sound balance sheets.

The chart below shows that technology stocks traded at 2x their profit share in 1999 versus just 1.25x currently. However, you have to be very careful with that statement. Valuations can adjust very rapidly, as they did in 1999. If the profit share falls, the valuation will go to 2x. Or, at current levels of profit share, a run to 6000ish will do the same.

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Furthermore, while sentiment is elevated, it is not in “bubble” territory just yet. In 2000, retail investor allocations were at 78% versus 68%. While the current level of equity allocations has been the highest since the financial crisis and the pre-COVID shutdown, it certainly doesn’t rule out a market top. However, equity allocations can certainly move higher to replicate the bubble frenzy of 2000.

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Of course, valuations are elevated based on the Shiller CAPE ratio but are not yet to previous bubble levels.

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Does this mean there is absolutely no bubble in the markets currently? No. That is the tricky part. Unfortunately, bubbles are only evident in hindsight.

 

Probably A Market Top

While we may not be in a full-fledged bubble yet, it doesn’t mean we aren’t on the way to that point. Investors are very exuberant, along with the media, and analysts are rapidly finding ways to justify excess valuations. In the near term, a market top is very likely. The market is currently up 17 of the past 19 weeks, the longest stretch since 1980. More importantly, the deviation of the market from the underlying 200-DMA is reaching rare extremes. Furthermore, as noted above, the market trades 3 standard deviations above the 50-DMA concurrently with market momentum and breadth deteriorating. Historically, such a combination was a decent warning of a near-term market top.

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Critically, this rally has largely been a function of the most stimulative fiscal policy in the last 15 years. Notably, stimulative fiscal policy tends to reverse quickly from previous peaks. In other words, the supporting driver of the market rally since the October 2022 lows will likely end in 2024 for whatever reason. The reversal of that fiscal stimulus will coincide with a market top.

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However, that doesn’t mean a market top will occur next week.

John Maynard Keynes once said, “Markets can remain irrational longer than you can remain solvent. “

Such is the problem with trying to “time” a market top, as they can last much longer than logic would predict. George Soros explained this well in his theory of reflexivity.

“Financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced. When there is a significant divergence between market prices and the underlying reality, the markets are far from equilibrium conditions.“

Every bubble has two components:

1. An underlying trend that prevails in reality and;
2. A misconception relating to that trend.

“When positive feedback develops between the trend and the misconception, a boom-bust process gets set into motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception get reinforced. Eventually, market expectations become so far removed from reality that people get forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow, and more people lose faith, but the prevailing trend gets sustained by inertia.” – George Soros

In simplistic terms, Soros says that once the bubble inflates, it will remain inflated until some unexpected, exogenous event causes a reversal in the underlying psychology. That reversal then reverses psychology from “exuberance” to “fear.”

What will cause that reversion in psychology? No one knows.

However, the important lesson is that market tops and bubbles are a function of “psychology.” The manifestation of that “psychology” manifests itself in asset prices and valuations.

 

Navigating Whatever This Is

‘I have no idea whether the stock market is actually forming a bubble that’s about to break. But I do know many bulls are fooling themselves thinking a bubble can’t happen when there is widespread concern. In fact, one of the distinguishing characteristics of a bubble is just that.” – Mark Hulbert

Whether you think the market is in a bubble or just forming a short-term top is mainly irrelevant. Every investor approaches investing differently.

However, if you’re nearing retirement or are a retiree, your investment horizon is shorter than that of much younger people. Therefore, given that you are less able to recover from the market’s deflation, it may be wise to consider the possibility.

So, what can you do to navigate the markets?

 

• Avoid the “herd mentality” of paying increasingly higher prices without sound reasoning.
• Do your research and avoid “confirmation bias.”
• Develop a sound long-term investment strategy that includes “risk management” protocols.
• Diversify your portfolio allocation model to include “safer assets.”
• Control your “greed” and resist the temptation to “get rich quick” in speculative investments.
• Resist getting caught up in “what could have been” or “anchoring” to a past value. Such leads to emotional mistakes.
• Realize that price inflation does not last forever. The larger the deviation from the mean, the greater the eventual reversion. Invest accordingly.

The increase in speculative risks and excess leverage leaves the market vulnerable to a sizable correction. Unfortunately, the only missing ingredient is the catalyst that brings “fear” into an overly complacent marketplace.

Currently, investors believe “this time IS different.”

“This time” is different only because the variables are different. The variables always are, but outcomes are always the same.

When the market corrects, the media will tell you, “No one could have seen it coming.”

Of course, hindsight isn’t very useful in protecting your capital.

 

How We Are Trading It

We remain in the camp that a 5-10% is coming over the next few months. Therefore, we remain cautious about deploying new capital and taking on excess risk in portfolios at current valuations.

With the earnings season behind us, the focus will return to the economic data and the Federal Reserve. As discussed previously, we have yet to see a meaningful rotation into value from growth, leaving this market confined to a tight trading range. We suspect that will change at some point, and our portfolio seems well positioned with some value balanced against growth for such a rotation.

Given we suspect a further correction is forthcoming, we suggest reverting to basic portfolio management rules to reduce portfolio risks for now.

1. Trim Winning Positions back to their original portfolio weightings. (ie. Take profits)
2. Sell Those Positions That Aren’t Working. If they don’t rally with the market during a bounce, they will decline when it sells off again.
3. Move Trailing Stop Losses Up to new levels.
4. Review Your Portfolio Allocation Relative To Your Risk Tolerance. If you have an aggressive allocation to equities, consider raising cash levels and increasing fixed income accordingly to reduce relative market exposure.

The market remains quite bullish, but that is also when the risk of a reversal is the greatest.

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