Melt Up?

This past week, Chairman Ben and the League of Extraordinary Bankers announced that there would be no tapering now but seemed to have left the door open for a sooner than later start for the beginning of the end…of the tapering.

In addition, we also had another all-time high in the S&P500; a 13 year high for the NASDAQ and the Dow closing within half a percent of its all-time high. (1) Even with the rally so far this year and its increase in valuations, the S&P 500’s price-earnings ratio remains below the 15-year average of 19.3, data compiled by Bloomberg show.

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 ultra-low rates have helped to make stock prices a bargain, at least in comparison with bonds. The emerging consensus seems to be that the rally might still go for quite a while, with the smart thing being to guard against a premature bailing out of this bull run.

So, why a melt-up?

As defined by Investopedia, a melt-up is a “dramatic and unexpected improvement in the investment performance of an asset class (like stocks, for example) driven partly by a stampede of investors who don’t want to miss out on its rise, rather than by fundamental improvements in the economy. Gains created by a melt-up are considered an unreliable indication of the direction the market is ultimately headed and melt-ups often precede melt-downs.”

While I can take issue with the unexpected part of the definition – after all, we’ve been trending up for 4 and one half years now – I feel it’s a good idea to bring it up so you’ll be kind of mentally ready in case the melt-down occurs…and to keep you from bailing.

Not a bubble

A guy I follow who has a great grasp of the market is Eddy Elfenbein. He recently offered this gem – “A bubble is a bull market in which you don’t have a position.” That not having a position is driving a lot of the recent upward market activity, in my opinion. Stocks still have plenty of small investor late-comers, along with those poor institutional investors who are now simply scared of missing out after only observing for the past four years.

I don’t see that quantitative easing has either increased inflation expectations or increased hiring in any real meaningful way. We continue to have great growth in our manufacturing, though the jobs still lag. Matter of fact, the US manufacturing sector expanded at its fastest pace in 2½ years last month. (2)

According to more than 11,000 analyst estimates compiled by Bloomberg, corporate profits now stand at all-time highs, so a portion of the gain in stock prices this year has simply been due to an expansion of multiples. PE ratios are now exactly equal to their long-term average. They added that profit growth will pick up this quarter, increasing to 6.8 percent and rising to more than 10 percent next year and in 2015. When PEs get to average around 20, or more, then we can talk about whether stocks are in a bubble.

My personal view of what constitutes an asset bubble is an extended period of over-valuation, combined with excess enthusiasm about that particular asset. We’re definitely not close to either situation, as enthusiasm remains very much a stranger to this market. The valuation case appears to be one showing the ability for higher prices over time.

A Wall Street legend, Abby Joseph Cohen of Goldman Sachs, had this to offer. She said, “How can the market do so well? Because the market started the year inexpensive, the PE ratios were too low. We still think the market is underpriced on a 12- to 18-month period.”

Market environment

John Stoltzfus, Chief Investment Strategist at OppenheimerFunds, had this to say about the market environment. (Bolds are his emphasis in the original.) “It appears to us that, over the last week or so, the same faces that successfully discouraged legions of investors from participating in the rallies that have followed the low of March 2009 have returned in force and onto the media landscape with the same argument that the markets advance is solely attributed to QE and other extraordinary efforts by the Fed.”

“We disagree. Since March of 2009, when equities began their rally from the lows of the Great Financial Crisis, the market, as illustrated by the S&P 500 performance, has reflected domestic and global challenges that ranged from banking sector troubles on both sides of the Atlantic, to fiscal and sovereign debt issues and persistent skepticism of the economic and market recovery. Anecdotally we recall that fourth-quarter angst has been nearly as common as a spring (April/May) market peak over the last two years or so.”

“We urge investors to stay focused on the many improvements in the economy that have been realized over the last few years, including: falling initial jobless claims, improved economic growth, increased hiring, rising earnings, improved consumer confidence, moderate growth and low inflation, higher home prices, strong car sales. All of the aforementioned have contributed to positive developments in services and manufacturing and have been reflected in the markets.”

Elliot Spar, market strategist at Stifel Nicolaus, offered this observation. “What will stop the market advance? When the market is in this mode, it may need a key reversal day, too many groups acting poorly (on the same day), the buyers just get exhausted or nothing at all.” By the way, a key reversal day is a trader’s term referring to a sharp reversal pattern that occurs during a trend. In an uptrend, such as we’re in now, prices would open above the previous day’s close, make a new high and then close below the previous day’s low. The greater the trading volume when that occurs, the more reliable the signal. No real way to anticipate such an event.

Conclusion

I truly believe that we’re in a bull market and one that can continue over the next few years. However, a bull market doesn’t mean “always goes up.” I think the fact that investors aren’t worrying much about the stock market right now and are seeming somewhat complacent is what’s behind the perception that we may be melting up.

Laszlo Birinyi, another highly regarded market strategist, offered this in his recent newsletter. “Historically, bull markets of this length and strength have a period of exuberance. 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.”

So, unless you’re a witch with a part in the Wizard of Oz, the bottom line is that melting – in any direction – is not something I think you have to worry too much about right now.

Cheers!

Mike

509-747-3323

(1)  CNBC, 1 Nov 2013

(2)  ISM report, 29 Oct 2013

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