Market Bubbles Create Financial Crisis and Opportunities

Market Bubbles: A Dire Warning to Investors

Investors are used to seeing bubbles forming and bursting; it’s part of the investing cycle. The 2000 stock market crash came about after the stock market bubble popped. The 2008 stock market crash can be blamed on both a stock market bubble and real estate bubble. In 2017 though, it’s a different story. It’s not just about stocks or housing; there’s the bond market, household debt, and scandals in Washington. Bubbles are forming everywhere and it’s presenting investors with a unique opportunity to profit. Stocks Stocks are near record levels and market volatility is at its lowest levels since 2007. With the bull-market in its ninth year, investors have become complacent. Thanks to the Federal Reserve’s generous bond buying program, interest rates sunk to zero and helped fuel the S&P 500’s 255% gains since bottoming at 666 in early March 2009. Because the current bull market is based on false assumptions, stock valuations have soared. The cyclically adjusted price-earnings (CAPE) ratio pegs the S&P 500 as being overvalued by 82%. The ratio compares current prices to average earnings over the last 10 years. The ratio is at 29.49 and the long-term average is 16.¹ The ratio has only been higher twice before, in 1929 it was at 30 and 1999 it was at 45. This does not mean the stock market is going to crash overnight. But when stock valuations get this high, it never ends well. Bonds After Donald Trump won the U.S. election in November, bond yields soared because investors were certain his pro-business economic policies would help boost the country’s gross domestic product (GDP) growth. Under President Obama, annual U.S. GDP was an anemic 1.48%. Overall, Obama oversaw the weakest period of economic expansion since World War II. Since the election, optimistic investors have been pricing out any economic positives expected to come from President Trump’s tax plans and stimulus spending. But the sentiment is changing and optimism is fading fast. Bond yields are falling, a sure sign that investors are more uncertain than ever that Trump will be able to get his proposed tax cuts and infrastructure spending through Congress this year. Thanks to gridlock and scandals in Washington, many are beginning to question if it will even happen in 2018. Household Debt U.S. household debt is now greater than it was in the lead-up to the Financial Crisis and Great Recession. During the first quarter of 2017, U.S. household debt hit a record $12.73 trillion, eclipsing the $12.68 trillion reached in the third quarter of 2008.² The U.S. household debt load looks a little different now. In 2008, housing debt totalled $9.99 trillion while non-housing debt was at $2.69 trillion. Today, $9.08 trillion is held by housing debt and $3.64 trillion in non-housing debt. While mortgages still account for the majority of U.S. household debt, student debt and car loans debt is way up. High interest credit card debt also continues to weigh down consumers. In fact, when it comes to the 90-day delinquency rate, credit card debt experienced the biggest increase. On a year-over-year basis, mortgage delinquencies have worsened, student loan delinquencies remain high, and auto loan balance delinquency rate continues to climb. With interest rates on the rise, U.S. household debt is going to get harder and harder to manage; especially when savings are depleted and wage growth is virtually non-existent. Scandals in Washington Nothing can rattle the markets like a Watergate-sized scandal. Whether President Trump’s woes will turn into the same kind of scandal is open for debate, in the meantime, all of the uncertainty could derail the Trump rally, put an end the bull-market, and send stocks crashing. We know this because it happened to the stock market when President Nixon was impeached. Shortly after Nixon was re-elected in November 1972, the stock market rallied, with the Dow Jones Industrial Average hitting 1,000 on November 14, 1972. By January 9, 1973, the Dow had climbed to 1,053. That was as high as it got. The Dow closed out 1973 at 850. Nixon resigned as president on August 9, 1974; that day, the Dow closed at around 777. Two months later, the Dow had fallen to 573. From the January peak to October 1974 trough, the Dow fell 40%. Stocks will start to crash if there is even a hint of impeachment. But this time around, Wall Street might not even need a Watergate to send stocks into a nosedive. If Trump cannot get his economic policies enacted it could lead to a further deterioration of U.S. GDP growth which could stymie the bull market.

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1. “S. Stock Markets 1871-Present and CAPE Ratio,” Yale University web site, last accessed May 19, 2017; http://www.econ.yale.edu/~shiller/data.htm.
2. “Household Debt Surpasses its Peak Reached During the Recession in 2008,” New York Federal Reserve web site, May 17, 2017; https://www.newyorkfed.org/newsevents/news/research/2017/rp170517.