Is the market’s record high just another bubble?

The Dow Jones Industrial Average hit a new all-time high on March 5 of 14,254, surpassing its old peak of 14,164 set on Oct. 9, 2007, and has continued to advance to still higher levels.

From this indicator alone, one would think that “we’re back!” Unfortunately, a review of the underlying fundamentals tells a different story, at least about the state of the economy. With weak fundamentals and high and rising stock prices, the logical question is, “Is the stock market in a bubble?”

In the accompanying table, besides the Dow Jones itself, only corporate profits per capita are better. That really has been the story for five and a half years. One might argue that corporate profits alone are enough to boost the market.

But, the markets always look forward, and today, a majority of reporting companies have guided downward for either top line, bottom line or both.

Why the equity market is rising

David Rosenberg (Gluskin-Sheff) has research indicating that, since 2007, the correlation between the Fed’s balance sheet and the S&P 500 index is 87 percent. The two major market dips since the great recession came when QE1 and QE2 ended.

According to Rosenberg, since the Fed now has another QE with no end date (QEnfinity), the market is continuing higher. As a result, he said, the rise in stock prices has been based on a P/E multiple expansion, and such a multiple expansion is solely based upon the Fed’s QE policies of money printing.

The evidence is that money printing is not about to stop any time soon despite market worries that some Federal Open Market Committee members are beginning to question the Fed’s easy money policies, which caused quite a stir in the bond market in late February.

In a March 1 address at the Federal Reserve Bank of San Francisco, Bernanke said,

“ … At the present time, the major industrial economies apparently cannot sustain significantly higher real rates of return; in that respect, central banks — so long as they are meeting their price stability mandates — have little choice but to take actions that keep nominal long-term rates relatively low…”

Why some bond managers worry and others don’t

Stan Druckenmiller, the famous hedge fund manager of Duquesne Capital, in a Bloomberg TV interview and again on CNBC in early March, commented that the coming onslaught of the entitlement promises will overwhelm the fiscal system unless something is done now.

He also said something that scared a lot of people. He said that as soon as the Fed sells the first security from its portfolio, every bond manager and investor will rush for the exits at the same time, which will result in chaos in the bond markets and is bound to spill over to equities. He points to the FOMC minutes and the market reaction in late February as proof.

On the other hand, Jeffrey Gundlach of Doubleline Funds, another famous and prescient fixed income manager, doesn’t believe the Fed will sell a single security in the current investment time horizon (which I interpret to mean several years).

Gundlach says questions about Fed tightening are the wrong questions to be asking. The Fed will keep interest rates low, not for months but for years because the math shows that if rates rose by any significant degree, the interest cost of the debt will overwhelm the federal.

Think about it. The Fed has observed the markets’ reaction to the FOMC minutes. Clearly, the Fed knows what the market reaction is likely to be if it began sales from its balance sheet.

So, I believe that Gundlach has the correct approach. However, Gundlach did issue a warning. The Fed, he said, might be able to print money for a while without any apparent consequences, then something dramatic happens. But, that eventuality still appears to be outside of the current investment time horizon.

Conclusions

Economic fundamentals remain weak. The stock market appears to be tied to the Fed, and as long as the Fed continues to print, the markets will have an upward bias.

While there could be equity market corrections, it appears that as long as the Fed continues its current policies, and as long as the economy at least continues to “muddle through,” then no serious bear market downdraft in equities is likely to occur.

The same is true for bonds, especially if the economic undertone and labor market conditions remain weak. So, the answer to the question “Is the stock market a bubble?” appears to be yes. But, it isn’t one that is likely to deflate any time soon.

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, Matt Marcewicz and Marvin Grulli) are available to discuss client investment needs.Call them at 775-284-7778.

Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.