Priced for Perfection: Mother of All Financial Bubbles… Or Market Has It Right?

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We have experience one of the most remarkable V-shaped recoveries of all time—the fastest market drop, followed by the fasted bounce back. We here the financial media and industry pundits declaring that the market has it right… but does it? Are we in the final stages of the mother of all bubbles? Or, are the markets right and the glory days are in front of us? One thing is for sure: We are priced beyond perfection—and that’s rarely a good thing!

The V-shaped recovery (or “check-mark” recovery for the Nasdaq) has been a thing of wonder. The S&P 500 at its current peak on June 8th was flat to how it started the year—despite the radically changed political, social, and economic landscape!

S&P 500 Performance Year-to-Date

And the tech-heavy Nasdaq is actually up—that’s right, up—10.4% on the year. To borrow a line from The Princess Bride, that’s simply inconceivable.

Nasdaq Performance Year-to-Date

The question then becomes: Is the market right… or, are we in the mother of all financial bubbles—one that will inevitably end badly?

The prepper community does a solid job of addressing physical themes (e.g., water, food, security, etc.); however, we feel that it is equally important to cover financial prepping matters. After all, the financial markets not only impact us personally but also as a society.

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Let’s take a look at where we’ve been, where we are, and where we may be headed—from a financial point of view.

2019: A Great Year for the Markets (A Retrospective View)

To fully grasp where the markets are now, we need to look back at 2019 and establish a baseline.

2019 was a remarkable year for the markets—the S&P soared 28.9% and the Nasdaq blasted-off to a mindboggling gain of 35.2%.

At the close of 2019, the “forward-looking” markets were priced for perfection.

To illustrate, lets borrow from the world of aviation. The markets represent a plane and our potential future growth represents a runway. At the close of 2019, we had a plane that was loaded to 100% of its maximum takeoff weight.

Furthermore, our “plane” was attempting to takeoff from an airport at extreme elevation and in the throes of a melting heatwave—meaning a very low-density atmosphere. This environment reduces the amount of lift an airplane’s wings can produce and, therefore, requires a much longer runway—especially at max weight.

So, how long was our runway?

I like to view runway length as a measure of the market’s outlook for the future—it represents the risk-reward balance. When the market is extremely optimistic and priced to perfection, it means everything must go perfectly and there is far more downside risk than upside. After all, it is hard to exceed “perfection” but very easy to miss that mark!

At the end of 2019, we were priced for perfection. Meaning, our plane had a ridiculously short runway from which to attempt a takeoff.

What were the reasons behind that pricing? Why were the markets pricing in so much optimism and priced for perfection? I would argue that there was one pre-condition and five primary drivers…

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Pre-Condition: 2018 Ended Very Badly

To understand the massive gains in 2019, it is first necessary to remember that it came on the heels of a massive selloff at the end of 2018.

Fears of a recession, rising Fed rates, and quantitative tightening were weighing heavily on the markets.

Then, we faced the worst Q4 since the Great Recession—adding serious weight to the fears of a global slowdown.

This is a perfect example of the markets pricing in a lot of pessimism and, therefore, providing a lot of upside potential (a long potential “runway”). If things didn’t turn out as bad as expected, if we even exceeded the low expectations by a little, then markets would start racing down that runway.

As we’ll see, that was the case in 2019. Reality greatly exceeded expectations, and our collective airplane took flight and soared to new heights.

Driver #1: Reversal of Fed Policy

As we noted, heading into 2019, the market was expecting rate hikes and expanded quantitative tightening from the Federal Reserve. That’s why the markets threw a bit of a temper-tantrum at the close of 2018—and the markets entered a significant correction as a result.

Easy money has become the drug of choice for the markets. Like a crack addict, the markets have become addicted to cheap money (aka low interest rates) and “free” money (aka quantitative easing or QE). When it looked like the flow of drugs was going to become restricted, the markets panicked and pushed back.

As a result, the Fed went from raising rates to three rate reductions in 2020 and ended its attempts to reduce its balance sheet.

In fact, in addition to three rate cuts and merely freezing its quantitative tightening, the Fed actually ended up returning to its quantitative easing efforts by the end of the year—pumping billions of dollars into the overnight repo markets via monetizing debt (aka a veiled form of QE).

These efforts were one of the drivers of last year’s big market gains.

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Driver #2: Rumors of a Recession Were Determined to Be Greatly Exaggerated

Remember, we entered 2019 on the tail-end of a major correction—one predicated on concerns about slowing growth (domestically and globally) and rising fears of a looming recession.

Thanks to the reversal in the Fed’s policies, the proverbial skies cleared, and the financial sun once again shone brightly. All concerns over a recession faded into the shadows.

The Fed emphasized that its reversal was just a preemptive tactic—a just in case financial vaccine. It was just an “insurance” policy, but things were going to be great and we were absolutely not headed for a recession. And the market bought it—hook, line, and sinker.

Driver #3: Rising Corporate Profits & Strong Employment

Third, 2020 saw a return to rising corporate profits—a lot of which was funneled into stock buybacks.

Were these profits legitimate—meaning predicated on actual economic growth? Or, were they the result of continuing to keep real wages stagnant for the workers? That’s outside of the scope of this article; however, I encourage you to read our article Exposing the Wealth Gap: Economic Inequality Is Driving Civil Unrest to learn more about this.

Regardless, this cash flow to the elite kept the market fires burning bright and the markets continued their meteoric rise and kept any thoughts of a recession in the rear-view mirror.

Driver #4: The China Trade Deal

Throughout 2019, President Trump kept the idea of a grand trade deal with China on the table. Every time the markets stumbled, he would tweet that his administration was making progress with the negotiations—and the markets would price in more good news.

Despite the fact that he was unable to deliver the promised “grand” deal, he was able to sell the outcome as phase one of a much larger deal.

Phase one was just the opening act—there was much more to come! And so, as if on cue, the markets took it as a victory and priced in the great possibilities to come in Phase Two.

Driver #5: Trump a Shoe-In to Be Re-Elected

The fifth and final driver of the tremendous market gains in 2019 was the presumed certainty that Trump would breeze to re-election.

Regardless of how you feel about politics or where you fall along the spectrum, the markets like President Trump—he is favorable from a business, regulation, taxing, and Fed-guiding perspective. After all, he acknowledges his tremendous focus on the economy and—more specifically—the financial markets. In fact, he has stated that he should be judged based on how the markets perform.

If there is one thing the markets hate above all else, it is uncertainty. Uncertainty makes it difficult to anticipate economic, business, and financial outcomes—you can’t plan or forecast over a long time-horizon.

The markets were comfortable with the fact that Trump would maintain his residency in the White House, and that the Republicans would maintain control over the Senate… and possibly make gains in the House.

Summary of 2020: Priced to Perfection

Thus, to summarize the overarching reasons the market performed so well in 2019, we can point to one pre-condition and five specific and material drivers:

  • Correction & Poor Expectations at the Close of 2018
  • Reversal of Fed Policy
  • Recession Taken Off the Table
  • Soaring Corporate Profits & Strong Employment
  • China Trade Deal (Phase I Delivered, with Expectations for a Big Phase II)
  • Trump Re-election All but Assured

Financial Markets 2020: Where We Are Now?

Currently, we have seen a massive V-shaped recovery in the financial markets. We are now largely back to, or above, where we were found ourselves at the close of 2019.

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If the markets were priced for perfection at that time, then they must be equally priced for perfection now—or even more perfect.

But are those underlying drivers—the very reason that justified the high valuations then—still in place today?

What one finds is that the only driver that still exists is the Fed policy of low interest rates and quantitative easing.

A recession—potentially a great recession—is now not only back on the radar but it is the reality for much of the world.

Corporate profits are going to be massively down (aka tank) due to the impacts of the pandemic, and we have roughly 40 million unemployed Americans.

The China Trade Deal no longer exists. Not only do we have to price out any possible Phase II, but we have back out the increase in valuation predicated on Phase I—China has made it clear that they will no longer honor anything they agreed to. We are now on a path to a cold war (at the very least an economic one) with China.

The political scene has been thrown into complete chaos. All bets are off now and Trump is in for the fight of his life going into the election in the Fall. Furthermore, not only is it highly unlikely that Republicans will achieve any gains in the House, it is entirely possible that they could lose control of the Senate. That means the probabilities have risen that the Left could sweep control of all three—the House, the Senate, and the White House.

Thus, we are nowhere near where we were six months ago. The markets may have attempted to rewind the tape or travel back in time, but it is NOT the same. We can put the market back to the same level, but we cannot put the world back to the same conditions.

The Mother of All Financial Bubbles: Where Are We Headed?

We are left with a market that is entirely decoupled from the real economy—meaning something has to give (i.e., either the market or the economy). Divergencies—even those temporarily supported by the Fed—cannot last indefinitely. Nature will always seek and achieve equilibrium.

The argument advanced by the bulls is that the market is merely looking forward and expecting a quick return to normal—thus it is pricing that expectation in (aka the market is right).

If that’s the case, then the V-shaped market recovery will require a V-shaped economic recovery. A V-shaped economic recovery will require a V-shaped employment recovery. And, all three will depend on a V-shaped global recovery—as our economy is intrinsically linked to the global marketplace now.

Is that what we see today?

Clearly, the answer is a resounding no.

Much like the financial collapse and subsequent great recession, this crisis will take years—not weeks or even months—to rebound from.

The expectation is that even when the dust finally settles, as much as 40% of jobs “temporarily” lost will become permanent job losses. Consumer demand will take years—if not a decade—to return to pre-covid levels. Bankruptcy numbers are soaring. And, we still have an unresolved pandemic that could rear its ugly head again—the wild card that simply adds more uncertainty.

And yet, market PEs are at dot-com bubble levels and PEGs are on a whole other planet—one we’ve never seen in the history of the markets:

S&P Current Valuation: Forward PE and PEG Ratios

And this data was as of May 28th—the values have just gone higher from there.

Is this really the best time to deploy your capital into the markets? You be the judge.

Now, I’m not saying short the market—it is never wise to fight the Fed (it is almost always a losing battle).

Yes, the Fed can prop the markets up for a time. However, even it has a limit.

When and if the people realize that the emperor has no clothes, everyone will head for the exits—and even all the power of the Fed won’t be able to hold that kind of selling pressure back.

Furthermore, at some point, the rest of the world is going to say enough! The Fed may be able to print as much money as it wants, but that doesn’t mean the rest of the world will agree and continue to back the dollar as the global reserve currency.

If the dollar was to ever be called into question—or, worse, dropped—it would be catastrophic. We would be talking financial, economic, and societal collapse in America on a scale that would make the Great Depression look like just a bad day at the office.

The Fed knows this. It fully understands that there is a limit.

I would argue that the Fed knew this all along. Its plan wasn’t to save the markets but, rather, to simply buy time—time to allow the elite to deleverage their risk and shift enough of their money into other assets to preserve their wealth (and ensure they stay at the top).

It will be main street that is left holding the bag when the restraint that is holding back the flood gates is released by the Fed. It will be the average Joe (and his 401K) and all those retail investors that got lured in by FOMO and the self-serving and disingenuous message of the elites that all is safe with the markets that will be devastated by the collapse/financial reset.

The wealthy will then swoop in when the bottom is finally in to deploy all that preserved capital to gobble up even more of the market—at fire-sale prices. We’ve seen this movie before… we know how this ends.

The top 10% own 92% of household equity in the markets. When this is over, they will likely own 97-98 percent. And their wealth will continue to exponentially grow—just as it did following the dot-com bubble and financial collapse.

The problem with the “don’t fight the Fed” argument is that you never know when the Fed is going to stop fighting or the masses are finally going to overwhelm it.

You can’t time the markets. Read and understand the signs. We don’t know when the collapse will start, but we know the season. We’re in that season and that’s close enough for me—don’t be greedy.

Conclusion

We are in the mother of all bubbles—one that has been building since before the financial collapse. It has only gotten worse (i.e., unbelievably more inflated).

We have a real divergence. The financial markets have become insanely decoupled from the real economy.

The day of reckoning is coming. The market is not right—the real economy is the correct measuring stick. The market will enter a massive correction to resolve this divergence.

Two problems rebut the claims of the talking heads.

First, we no longer have the conditions we had at these same market levels at the end of 2019—conditions that occasioned the “priced for perfection” valuations.

Second, we don’t have even the slightest hope of a quick V-shaped recovery for our economy, our employment, or the rest of the world.

No one knows when that collapse will come—but it will come. There will be a turning point—when the occupants start to head for the exits. Panic will ensue as more and more fight to get through the door as they watch their investments and life savings evaporate. We are approaching Q2 earnings season—that may be the spark that starts the inferno. This may be when folks realize things are worse than they thought—much worse.

Regardless, once it starts, the Fed cannot and will not stop it. That was never its mission. It was not created to care about you, the commoners on main street. It exists to protect the wealthy and ensure their continuity as the elite and ruling class. It has accomplished that mission by buying time.

Situation awareness is always critical for surviving a crisis. Your financial survival is not different from any other aspect of preparedness. Don’t be fooled by the smoke and mirrors, misdirection, and sleight of hands. The market is going back down—and it’s going to be taking the express elevator. How far it will go is anybody’s guess.

Make sure your financial house is in order! If you have an investing time-horizon of greater than ten years, then you can probably ride it out. If not, you may want to consider following the game plan of the rich and move your money to a safer asset to preserve it.

Either way, this is probably a good time to lock in some profits and stash some cash on the sidelines—especially highly risky investments you may have benefited from (but will become a boat anchor pulling your portfolio down into the murky depths).

In a financial crisis, cash (or a highly liquid cash equivalent) is king. Make sure you have enough!

As the saying goes, “Be greedy when others are fearful, and fearful when others are greedy.”

Take a look at market sentiment as expressed by the put-to-call ratio. We are at extremely bullish levels–levels not seen since 2011 and levels that typically trigger a meaningful trend change:

Total Market Equity Put/Call Ratio (EOD)--Extreme Bullish Sentiment

Now is definitely NOT the time to be greedy!

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