Irrational Exuberance Part III ?

Federal Reserve Chairman Alan Greenspan used the words "irrational exuberance" in a speech to the American Enterprise Institute on December 5th, December 1996:

"Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?"

Robert Shiller, the latest winner of the Nobel Prize in Economics, then used the same words as the title of his well timed book as published in 2000 following one of the all-time greatest stock market tops in U.S. history.

In early 2000 when the "Dot Com" bubble started to burst, the Nasdaq Composite peaked in March at 5132 and then proceeded to fall nearly 80% to its final low at 1108 in October 2002. Over the same time period the S&P 500 Index plunged 50% from 1553 to 769.

In valuation terms, how does today's U.S. stock market compare to the market in March 2000? Always tough to make these kind of comparisons, but the Shiller 10-year Cyclically Adjusted Price Earnings (CAPE) ratio might be a useful tool here. The mean value for this ratio over the last 150 years has been 16.50. Let's call this "fair value" for the S&P 500 Index. The record low was posted in December 1920 at 4.78, while the record high was set in December 1999 at 44.20. The current CAPE ratio is 26.30, which means that the S&P 500 Index is about 59% overvalued right now. For historical reference, the Shiller CAPE ratio traded near 30.00 in late October 1929 just before that market crashed.

Attached is the latest Investors Intelligence sentiment survey which shows 59.6% bulls and 14.1% bears. The ratio of bulls to bears at 4.23 : 1 may not be the highest in history, but it's the highest I've ever seen. The latest AAII sentiment survey shows 55.1% bulls and 18.5% bears. I've seen a greater spread here a few times, but not many. Of course, if you believe in "contrary indicators", then these two surveys alone will have you more than a bit nervous with any long stock positions.

Like many stock market technicians, I love the abundance of free stock screening software now available. My favorite is located on www.finviz.com where I have developed two simple screens to find potentially "undervalued" and "overvalued" stocks. Both screens were designed to reduce the set of 6,500 listed stocks to less than 50 that meet certain criteria. From there I could then research each individual stock to see if an investment is warranted. While each of my two screens has at least six criteria, the backbone of my overvalued screen is the simple test that the "Forward Price / Earnings Ratio be greater than 25". For the undervalued screen, the Forward P/E must be less than 15. All the other criteria are important, of course, but the "Forward P/E" variable is the over-riding consideration in both my screens.

Last year at this time, my undervalued screen produced 17 stocks. Now there are just 2 names on this list. For the overvalued screen, last year at this time there were 39 stocks on this list. Now there are 165 names, a record high number of overvalued stocks from my simple overvalued stock screen. Of these 165 names, 24 are currently trading at more than 100 times 12-month forward earnings estimates. And 33 of these 165 stocks are actually trading at greater than 10 times trailing twelve month sales! These are incredible numbers!!

After my simple screens generate their overvalued and undervalued stock lists, I then perform a second level of algorithms to further dissect and rank the stocks on each list. For those that are curious, here is my current list of "The 25 Most Overvalued U.S. Stocks" as of Friday's close, December 27th:

Bottom Line: The U.S. Stock Market is now in the final days of a "record setting bubble" that is about to burst. There are too many bulls among often-wrong trading groups. Dangerous leverage, as measured by investor margin debt, is now at a record high. Valuation measures like the Shiller Cyclically Adjusted Price/Earnings Ratio (10-year at 26.30) are now screaming "sell everything". The Federal Reserve has already announced its intention to scale back monthly purchases of Treasury securities and Mortgage-back Obligations. The 10-year Treasury yield is now above 3.00%, having risen from 1.61% in May 2013 and a low at 1.39% in July 2012. While monetary policy must still be considered "accommodating", it is clearly less so now than a year ago. It seems to me that all the best possible news on corporate earnings, fiscal and monetary policy, and even prospects for the global economy are all fully factored into current stock prices. In the interest of full disclosure, I am long Gold/Silver mining shares and short the S&P 500 in the accounts that I manage. Is that a Black Swan I see on the horizon?

Courtesy: Yardeni Research, Inc. (www.yardeni.com)

U.S. T-Bond Prices - Weekly Chart Buy Signal ?

A weekly chart buy signal was triggered in my computer-based trading system at Friday's close in the U.S. T-Bond ETF (symbol TLT, please see chart below).

How is this possible given the following:

1. The U.S. Census Bureau reported this past Friday morning that its third estimate of third-quarter U.S. gross domestic product (GDP) rose at an annual rate of +4.1%. That was sharply higher than the 2.5% growth rate for the second quarter and significantly better than the second estimate issued only two weeks ago calling for an increase of +3.6%. The Census Bureau said that the jump was due to larger personal consumption expenditures (PCE) and nonresidential fixed investment. (Normally considered bearish news for T-bond prices.)

2. The Federal Reserve announced last week that it will soon begin to scale back it's monthly purchases of Treasury securities and Mortgage-backed obligations (the infamous Taper). (Normally considered bearish news for T-Bond prices.)

3. There is a near-universal view right now that economic conditions in the U.S. and across the globe are continuing to improve, with expected lower unemployment rates, greater investment, and increased productivity. (Normally considered bearish news for T-Bond prices.)

Of course, in the world that I see, the buy signal in T-Bond prices makes perfect sense! And here's why:

1. I believe that U.S. economic growth is about to slow dramatically from the 3rd quarter pace of +4.1%.

2. The U.S. stock market is about to experience a violent correction.

3. The CBOE "Skew" Index rose above 140 for only the 4th time in history this past Friday. The Skew Index basically measures option premium levels within the S&P 500 Index for extreme out-of-the-money exercise prices. An average Skew reading is 115 according to the CBOE. Extreme readings (>140) suggest that "smart money" traders believe there may be an increased probability of a so-called "black swan" event.

4. JP Morgan is attempting to limit potential losses on its clearing of Target debit and credit cards following a major security data breach involving 40 million Target cards. JP Morgan is limiting cash withdrawals and also spending purchases. Not exactly the best timing for this sort of SNAFU.

5. For bullish stock investors, there is no "Wall of Worry" to climb now. However, this fact is NOT bullish! All the "Good" news is already priced into share prices. Any potential "Bad" news, like disappointing corporate earnings or a negative liquidity event (JP Morgan?), will be quickly met with an avalanche of selling and lower stock prices.

Bottom line: Coming into Friday, T-bond prices were oversold on a technical basis and sentiment indicators reflected too much bearishness among often-wrong trading groups. A rebound should not have been a surprise, but I was surprised none-the-less. It's not hard to imagine that T-Bond prices will continue to rebound as shorts cover and legitimate "flight-to-quality" issues present themselves over the near term. Gold/Silver mining shares continue to look extremely attractive to me, and the overall U.S. stock market (as measured by the S&P 500 Index) continues to look vulnerable to a major correction. In the interest of full disclosure, I am long Gold/Silver mining shares and short the S&P 500 in the accounts I manage.

U.S. T-Bond ETF (symbol TLT) Weekly Bar Chart with Computer-based Buy & Sell Signals

Is The "Book" Really Closed On Gold ?

Here is an interesting quote from this afternoon's Wall Street Journal "Online" Edition: 

"Gold prices slid to three-year lows [today], effectively closing the book on a historic rally that lured investors on both Wall Street and Main Street."

Almost every mainstream financial publication has a negative story this afternoon on Gold. Most point to the latest announcement by the U.S. Federal Reserve yesterday  that it will "taper" its purchases of Treasury securities and mortgage bonds from $85 billion/month to $75 billion/month.Others claim that selling pressure will persist in the Gold market because the global economic recovery is getting stronger and that 2014 will surprise on the upside in terms of global trade and related commercial growth. Still others point to several "masters of the universe" who have exited gold with heavy losses as a contributing factor to this year's slide.

The climate for gold and precious metals investment is so negative now that there is even talk of removing Eric Sprott as manager at Sprott Asset Management. Eric Sprott may be among the greatest portfolio managers of all time in the precious metals mining stocks arena, but some of his funds are down as much as 50% this year so far.

Is the "Book" really closed on Gold? As I write this column (9:30 PM CT), the near-term Gold futures contract is trading about $1193. Will it soon fall to $1100? Is $1000 the next real support in this market? Of course, gold prices could decline further to these key levels, but I just don't see this scenario unfolding anytime soon!

According to the U.S. Commodity Futures Trading Commission, the net-long position in Gold futures and options contracts is now at its lowest level since June 2007. And short positions (bearish bets) have very nearly risen to the levels witnessed in July 2013 when gold prices posted a significant short-term bottom. And global holdings of exchange-traded products backed by Gold have fallen to their lowest levels since March 2010.

And despite the fact that Gold is a "slam dunk" sell here according to analysts at Goldman Sachs, China keeps buying. China is buying gold at a rate of more than 100 metric tonnes every month now. This represents approximately half of the entire planet's annual mined output. Since gold jewelry sales account from more than 1,000 metric tonnes per year, China is effectively buying ALL the world's mined output every month.

In the interest of full disclosure, I now have about a 40% allocation to gold/silver mining shares in the portfolios that I manage. In one of them, I have hedged these long positions with short-sales in the S&P 500 Index. Yes, Long Gold Mining Shares, Short the S&P 500. Interesting position!

Bottom Line: One factor not talked about much with respect to the recent declines in gold, silver, and related precious metals mining shares is "tax loss" liquidations. Most of the shares in this unloved industry are down more than 50% this year so far, and some are down as much as 75%. Today is December 19th. The end of tax loss selling season is nearly done and conditions are ripe for a wicked short-covering rally which will then turn into a massive new bull trend. I strongly believe that Gold/Silver mining shares could easily rally 50% or more over the next 90 days. The upside spring is wound tight for Gold and Silver, and precious metals mining shares will be the star performers over the next several weeks AND for most of 2014.