The Dangers of a Stock Market Melt-Up; Though a steadfast market bull, a strategist worries about investors’ nonchalant attitude toward ever-rising stocks

November 2, 2013

The Dangers of a Stock Market Melt-Up

By JEFF SOMMER

Investors aren’t worrying much about the stock market, and that worries Edward Yardeni.

It’s not that Mr. Yardeni, an independent economist and strategist, has a gloomy outlook on the market himself. To the contrary, he’s been generally optimistic about the prospects for stocks for about five years, and he remains so. “We’re in a bull market, and I think it can continue for the next few years,” he said in an interview last week. But what’s striking about his perspective is that while he remains a steadfast market bull, he finds himself increasingly preoccupied by a cloud on the horizon: the growing complacency of his fellow investors.They keep bidding prices higher and higher, with a speed and consistency that troubles him. In a word, he is worried that we may hurtling into a trajectory that cannot be sustained — what he calls a market “melt-up.”

“The bull market would be more sustainable if investors fretted about all sorts of possible bearish problems,” he said. The economy isn’t all that strong, for example, and it might be much weaker if the Federal Reserve were not holding interest rates artificially low and buying bonds at a relentless pace. The Fed decided on Wednesday to continue its easy monetary policy, but it will have to tighten up eventually, perhaps causing stresses in the markets.

People aren’t worrying nearly enough about such things for his taste. “That,” he said, “is making me a little bit nervous.”

Of course, the market is not in perpetual upward motion; it fluctuates daily. After reaching a high on Tuesday, the Standard & Poor’s 500-stock index dropped on Wednesday, dipped slightly Thursday and rose on Friday. But whether the news has been good or bad, investors have remained remarkably unruffled — and stock prices have trended higher, without a major break, for a very long time.

Based on valuations like the price-to-earnings ratio, we’re not in a full-blown asset bubble at the moment, in Mr. Yardeni’s view. Corporate earnings have increased steadily, and he contends that they will keep doing so, providing the foundation for a rise in the stock market for some time.

But he says there is now a significant danger that excessive exuberance could threaten the market’s climb.

“I expect the market to rise,” he said. “But I’m worried that it could just go through the roof. If it does that, we could have a nasty correction afterward, maybe a bear market, and that could cause serious problems for the economy.”

After all, there hasn’t been a significant market correction — defined as a drop in average share prices of more than 10 percent — since a 19.4 percent decline in the S.& P. 500 in 2011. (After stock prices drop 20 percent, a correction becomes a bear market, in Wall Street parlance.)

And since the start of 2012, the market has never been in negative territory for a calendar year. Since the market nadir in March 2009, the S.& P. 500 has already returned more than 180 percent, including dividends. Under conditions like that, it’s been hard not to make money, if you’ve been wise or lucky enough to have had money in the stock market.

There are many signs that people are no longer worrying all that much about the possibility of another market meltdown, of the kind that occurred in 2008, when the S.& P. 500 returned a negative 37 percent, dividends included. A global financial crisis and recession brought the economy to a perilous state back then, but for several years now, the Fed and other central banks have been flooding the world with liquidity.

In its meeting last week, the Fed again delayed carrying out an exit strategy, or taper, from its bond-buying program known as quantitative easing. Janet L. Yellen, the Fed’s current vice chairwoman, has been nominated to succeed Ben S. Bernanke at the helm, and she will have to deal with some delicate issues for the markets.

Short-term interest rates remain extraordinarily low, and with the debt-ceiling crisis and partial government shutdown already fading into the past, medium- and longer-term rates have receded, too. These ultralow rates have made equity prices a bargain, at least in comparison with bonds, according to most financial models.

As the Fed’s balance sheet has swelled — it is heading toward $4 trillion, according to a new Fed study, up from $800 billion before the financial crisis — the stock market has risen, and many investors have noticed the correlation. While there is still plenty of money on the sidelines, many investors are responding enthusiastically now — excessively so, in Mr. Yardeni’s view.

One widely followed gauge of market sentiment, the Investors Intelligence Bull/Bear Ratio, soared last week to 3.19 from 1.96 two weeks earlier. (The percentage of market bears fell to 16.5 percent, the lowest since May 2011.) Ratios of 3.0 or higher have often signaled the onset of corrections or bear markets.

Mr. Yardeni isn’t the only longtime bull to note the possibility of a melt-up. Laszlo Birinyi, an independent strategist based in Westport, Conn., did so in his current newsletter, called Reminiscences. “Historically, bull markets of this length and strength have a period of exuberance,” he said. “It doesn’t have to happen but it usually does and we would certainly leave the door open for what is termed a melt-up.”

Still, he reiterated his conviction that the bull market’s legs are strong enough to carry it considerably further — if excesses or external shocks don’t batter it too badly. And so did Mr. Yardeni, picking an easy-to-remember target of 2,014 for the S.& P. 500 next year. (It was nearly 1,762 on Friday.) “I just hope the market doesn’t blow right past my target in the next few months,” he said.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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