The recent gyrations of the market have brought back the
question of bubbles and market trends.
A “bubble” is an abnormal inflation of a type of investment
in proportion to other investments. The
classic is the Tulip mania of the 1630s. More recent episodes are the Nasdaq
frenzy of the late 1990s and the housing bubble of the previous decade.
In each case, the investment in question edged out other
investments and became inflated in value in relation to its typical place in
the market.
I’ve noted many times that quantitative easing has inflated most
assets together. Although there are some distortions, the fact remains that the
market as a whole is not in a bubble.
To calculate a “bubble” environment I have multiplied the
birth rate plus 46 years (i.e. the average age of the American work-force) by
the Fred M1 money supply and plotted their current deviation from a 1959 to
2015 regression. That value gives a
current deviation of 0.0721797.
Next, I’ve done the same for the S&P itself during that
same time period, with a current deviation of -0.035329.
If we SUBSTITUTE the demographic * money supply deviation
for the price deviation we see a fair value for the S&P to be 2250.
I’ve plotted this graphically:
A few points. First, secular bear markets show fair value
trailing behind price, while secular bull markets show price trailing behind
value. We certainly DO have an
artificial market environment, with price and value tracking in lock-step.
Ordinarily this would still be a secular bear, but quantitative easing has camouflaged
that fact.
As I’ve argued routinely in previous posts, the market isn’t
due for a crash because it actually hasn’t risen in real value. It just looks
like it has been going up because of all the M1 money supply expansion. Even
Shiller’s CAPE ratio is distorted by the disconnect between inflation and money
supply.
The next obvious point of the graph is what a bubble
actually looks like. The 2000 and 2007
peaks are wildly inflated, even on this logarithmic chart. They are
spectacularly obvious.
And the final point is that the market is not above fair
value. Instead, it is almost 12% below
fair value.
Bear markets are routine.
Crashes are not.
A bear market can come at any time, and the leading / lagging
sectors show a preference for defensive sectors right now. I do expect more correction to follow, even
up to a bear – but I do not expect a 1929, 2001, or 2008 style crash. The worst we could see would be a 1987 type
event – annoying, but not disastrous. I would be afraid of too much margin
right now, but there is no reason to dump non-leveraged investments.
I don’t time anyway, of course. But even if I were a market
timer, I’d leave my non-leveraged investments in place.
Tim
Hi Tim,
ReplyDeleteIf M1 comprises only the most liquid types of money (coins, notes and the like), how is the Fed involved in it? The money the Fed injected in the economy was not M1-money. It is digital money that still sits on the accounts of the banks who 'refuse' to put it at work for the real economy.
How do you see this?
Regards,
Wil.
Hi Wil,
ReplyDeleteThe fake money frees up the real money by reducing the required reserves of real money (or at least that's my best guess).
Tim