The past few weeks, I have been arguing against the notion that we are in a bubble.

Let’s look at the other side of the argument: What is the (rational) bear case? We know stocks are no longer cheap, and this bull — already up 160%+ — is on the high end of the range.

What are the legitimate bear arguments?

This is an open thread — make your best case!


Category: Investing, Markets, Psychology

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

57 Responses to “Open Thread: Make the Bear Case”

  1. I may take the best of these and turn them into a column

    • azubto says:

      Since 2011 S&P earnings up 15% and index up 45%.
      QE not helping economy – Fed helping the 1% – which got us into this mess.
      Bond market revolt with or without taper.
      Middle class continues to get beat up – doesn’t bode well for the economy.
      Deflation setting in Europe.
      I continue to wonder what will drive growth in our economy?

    • jwhjkh says:

      While S&P 500 earnings increased, EBITA decreased since 2010. Higher interest rates will decrease both.
      The housing recovery will falter with higher rates and almost zero first time buyers. Ditto for car/truck buyers.
      Politicians will make a mistake. I don’t know what or when, but they will.
      Higher health care premiums will reduce discretionary spending.
      Black swan: Japan, South Korea and China dispute escalates with trade restrictions.

  2. Frilton Miedman says:

    The chartists say the Dow/SPX finally broke resistance after two attempts in the last decade –

    To them, I say see 1973.

    Fundamentalists cite P/E’s, to them, I ask what the P/E is if minimum wage is (or isn’t) increased, or there’s a job boom that increases domestic labor demand…..or. cold fusion is discovered and our fracking boom comes to a halt.

    I have no clue either way, everything rests in D.C., fiscal policy and what unfolds over the next year.

    Sad but true, maybe the best way to explore what will tip the scales is to look on

  3. BearPaws says:

    It begins with the FED having bought every 10 year equivalent. I think they’re at 30% now.
    After they own everything they’ll begin to taper. So, the bear case begins at DOW 60,000 in about year and a half.

  4. matt wilbert says:

    I think the medium- to long-term bear case boils down to valuation. The market looks more or less reasonably priced given current sales, interest rates,and profit margins. If any of those things changes unfavorably the market is going to be pretty expensive. The short term case is sentiment; there seem to be a lot of bulls and not so many bears right now.

    I’m afraid I’m one of the sanguine ones who is screwing up the sentiment indicators, although I did raise some cash this week.

    • willid3 says:

      not sure that they are ‘reasonably’ priced. sales have been tanking for almost all of the companies. can’t imagine why that is. but may have some thing to do with lower incomes, and not wanting to get back into the ‘credit’ game again

    • pdzxc says:

      Many pundits point to market P/E rations and say they are average to slightly above average for a low interest economy. But they fail to take into account that interest rates are being manipulated lower by the Fed, or with interest rates suppressed by the FED, that corporate interest expenses are well below average. What would profit and P/E ratios be in we had market based interest rates? Not surprisingly given the low interest costs, corporate profits as a percentage of GDP are 70% above their historical record.

  5. chartist says:

    I can only think of one: some well known bears have turned bullish.

  6. tjandthebear says:

    The bull market now is the same as it was in the mid-2000′s… a charade orchestrated by the Fed.

    Any argument of bull vs. bear based strictly upon valuations is therefore incredibly superficial.

  7. 4whatitsworth says:

    Truthfully I am in the we go no where for a while camp but here goes..

    It is hard to imagine unwinding QE gracefully I believe the best case is that once this begins we go into a trading range. There is a high probability that once the unwinding really takes hold interest expense will go up and revenues will not for the S&P 500 companies that is good for a 10% slide then fear of being the last one out just when you had enough to retire crowd will get involved. I don’t think it is much more complicated than that.

    • winstongator says:

      I think this is it. You get a 10% reduction that is a mix of higher interest expenses and people selling on QE’s end. That 10% pushes out the last 10% of money that has gotten into this market (retail investors buying near the top). So you get a 20% reduction. Herd behavior could take 20% to 30%, and we’re close to DOW 10k.

  8. Maggie says:

    1. We’ve wrung as much as we can from QE; time to wrest it.
    2. We’ve gone through gold and bitcoin.
    3. People have a new found confidence putting the petrochemical industry in their place.
    4. We want our own space and can’t afford much of it, if any.
    5. “Horatio Alger Myth”
    6. Most of us aren’t that bad off we just whine a lot.
    7. Nat’l motto: “From my cold, dead hands.” I’m thinking: Cash & Ammo. (Good Movie title?)
    8. It took Goldilocks three tries before she found something just right and then the bears came home.

    Then again, never underestimate our innate ability to exploit anything and the roles we all play in it before most of us will acknowledge that it is happening.

    • Frilton Miedman says:

      RE #6 – How many full time Walmart, retail or fast food workers do you know?

      I know none, I don’t presume to know what it’s like to feed a family on $300 a week, but I can assure you – I’d be “whining”.

      If your reply is “they chose that life”, explain why each job vacancy has 3 applicants.

      • Maggie says:

        Oh Mr. “Miedman”,

        You mistake my sarcasm and wages could very wel be one of the driving reasons that we are headed right into a bear’s den. We are a consumer products driven economy and yet we have always been loathed to pay retail industry workers a decent salary and provide them with healthcare, profit sharing and pension. Ask Scrooge Walton’s spirit this holiday season if he happens to pay you a visit. We want robots!

        I remember when being a supermarket employee was a great thing but they were unionized back then. Yes, things have changed. We are more automated in every way and yet service seems to suck but with a forced smile.

        The collective “we” in the United States is generally well off and I have personally, acutely felt the growing divide, economically, over the past twenty years. C’mon! Compare us to India, Africa, North Korea, Russia, South America, etc. We are lucky and well off from this perspective.

        I agree with you about feeding, housing and clothing yourself much less a family on $300 a week. It’s impossible! without assistance but we still stigmatize any kind of social programs and think of it as charity and yet zero population growth isn’t such a good thing either for an economy.

      • Frilton Miedman says:

        Alright “Maggie”,

        We’re on the same page, and as a biz owner, to put a “selfish” spin (vs being accused of “Socialism” by fans Ayn Rand fiction novels & appeal to those who glean their understanding of economics from Fox)) on the point of disparity, I need more customers with money, it’s just that simple.

        if only 1% of the populace is making more, that means, per capita, only 1% of my clients can buy more from me.

        This Congress, specifically the GOP, is a COMPLETE flop, this “recovery” is only because % of household income to service debt is equal to where it was in 1980, while actual household debt to income is up 70%, and wages are flat over the same period.

        Ultimately, to stick with BR’s theme, my bearish case lies in politics – keep an eye on 2014 elections, if the Koch brothers manage to buy their monarchy, I’m extremely bearish.

        One more two year period of GOP, Koch brothers dominated House, and this year is only a repeat of 1973, we’re in for a dive lower than 2009.

        The Fed cannot keep this up alone, Bernanke has said this repeatedly, there’s NO way of avoiding the empirical data on household net worth, it all hinges on whether voters can be brainwashed the way they were in 2010.

  9. pianodoctor says:

    I think historically when markets smell a recession, they go down. They also tend to go down in the case of a change of Fed chairmanships, because of the uncertainty of what new leadership will mean. We know we are going to have a change of Fed chairs. As far as recession goes, what are the chances the Fed can keep such perfect control in a ZIRP environment that they keep pushing GDP up into the indeterminate future and that no further ‘accidents’ or other black swans will occur after so many years of continuous growth? My guess is one thing or the other happens sooner (2014) rather than later.

    • pianodoctor says:

      I wanted to edit my comment above but cannot find the function do do so. I wish to give full credit to Eric Janszen of iTulip for his excellent analysis work on which I base my above opinion. The Q was “what are the legitimate bear arguments?” and while trying to express that, I didn’t mean to come across that the opinion expressed was original to myself.

  10. eren says:

    I have turned bullish last week. that’s enough for the bear case.

  11. rd says:

    The four valuation measures that Doug Short tracks are in quite over-valued territory. Wilshire 5000 compared to GDP is over 110% which is moving towards very over-valued territory. These measures are generally in the top 10% or so of readings for their history.

    Margin debt is at historically high levels. This is not a trigger but can add fuel to the fire of a downturn turning a correction into a bear as forced sales occur.

    S&P 500 sales have not been rising at anywhere near the rate of stock market growth at a time when profit margins are at highs. There isn’t much room to to get more earnings unless sales go up without costs rising significantly. That is difficult to do late in a business cycle when it is difficult to expand production without labor costs rising.

    Similarly, the Fed has very few arrows left in its quiver. QE seems to have less and less impact and there is nowhere to go with the Fed funds rate except up.

    It seems like the market is going up on momentum and optimism. The multipliers have moved up to the upper end of the normal bull-market range. The stock market is viewed as the alternative to trash is case and low bond yields instead of being a good investment in its own right.

    So the technicals still don’t look too bad for the market, but it is probably living on a knife edge where any type of slow-down in the economy, corproate revenues, or earnings could send this market south in a heartbeat. The typically valuation metrics combined with high margin debt would indicate that a bear would likely get ugly with 40%+ declines due to a rapid change in investor sentiment as their hopes get shattered.

    The Fed seems to have done a very good job preventing corrections since 1992. However, it seems like the markets save up those corrections over the years and release them in 60% crashes instead.

    • catclub says:

      I know it is foolish to say ‘This time is different’ so the historians will need to tell me how it is more the same:
      1. margin debt at historic levels. Is this absolute, ar somehow scaled by the size of the market.
      I.e What fraction of stocks are on margin compared with previous high levels.
      2. margin debt: interest rates are very low, so any carrying costs will be lower than in previous cycles.

      3. How do we evaluate ‘high’ PE ratios for comparing cheap to expensive when interest rates are so low? In this environment, minimal yield is still beating bonds.

      4. My wish is to be told that Fed has already been tapering for few months, … and the world did not appear to end. This is in contrast to my desire to yell: WHY taper when inflation is non-existent and unemployment is still far too high?

      • rd says:

        I believe nominal margin debt is at an absolute high but is a little bit short of the inflation-adjusted high that occurred in 2007.

        The carrying costs are very low. However, you can only make real money based on capital gains, not dividends since dividend yields are also very low. Besides, the brokers don’t care what interest rate your margin debt is costing you when the market starts falling. They will just call you to pony up cash or sell your holdings.

        I suppose that we could have PEs go to infinity and beyond with low interest rates. However, investors usually expect that they see the return of their money with reasonable profits within some reasonable time horizon. We are starting to move that time horizon out to the outer bounds of what investors have historically looked for in those time horizons. If investors start to get doubts on getting their money back in a reasonable time frame they may elect to bail.

        Also, do we really think we are looking at zero-bound rates for the next 20 years? How would we justify assuming any sort of serious profit growth during a period like that?

  12. horsetradin says:

    I keep coming back to the inflation adjusted DOW making a triple (or at least double) top.

    I know JC Parets makes a case other wise,

    but I still think it strongly material and probably is best suited for stripping out effects of FED chicanery and also currency effects.

    Seems interesting too that we haven’t really had a black or even grey swan event lately.

  13. badaitz says:

    Real unemployment probably 15% or higher. People are falling off the books everyday and that lowers unemployment. Every year at this time higher is done for the Christmas season and ever year the street seems to be happily surprised that this happens. After Christmas there will be layoffs, as usual, and unempoyment will go up, job creation will go down–shocker.

    The talking heads on CNBC are nothing more than mouth pieces for Wall Street and to me stocks are where gold was 18-20 months ago–there is no bad news, all news is good news or spun to be good news. There is no rationalization for the market to be screaming up as it has, sure it can be spun, or the bar can be set so low companies can help but beat expectations. Most of the time they are improving profits by laying off employees–taht can’t be good in the long run.

    People are hurting, they are one major accident, health problem or layoff from bankruptcy. I keep hearing there is no inflation, yet I am paying more for everything every time I shop. I might pay the same price for a product, but I getting less of it each time, it’s smaller. I keep hearing that inflation stands at (pick a number) and that’s just total BS.

    The market will tumble, but not until the public is fully invested. With CNBC and the other talking heads pushing the public into the market it shouldn’t be long. Then what, another round of mea culpas?


    • ccachor says:

      Real unemployment is probably 20-25%. They just shifted people from unemployment to disability. I completely agree with you – we’ve got wages that have stagnated for quite a while and with continued downward pressure. I know CPI says one thing – but I feel discretionary spending is way down. Take away equities and most people are broke – plain and simple. Until we see a nice rise in wages, this economy will continually need propping up.

  14. jankynoname says:

    I think this cycle will break with housing (much as the last one did). We’ve gone through the first ‘wave’ of the housing recovery already; investors/P.E.s have already gotten in, and will soon look to exit their positions with tidy 20-30% gains in home prices (~60-100% returns on equity in little over two years). For the housing recovery to continue, we need true, real, 1st time buyers to come back into the market… but it doesn’t look like this is happening. Millennials have virtually no savings and the ones how have strong income potential (JD/MBA/MD/etc) have spectacular student loans to repay. The next older age group (e.g. late 30s-40s) has serious credit impairments after many went through foreclosure/delinquincy/layoffs in the last cycle. Boomers are largely going to be a non-event for the housing market from here on out, as older people tend not to move much. So I think home prices breaking down + housing starts remaining below prior recession troughs + high expectations for a housing recovery in the stocks (homebuilders, industrials, materials, banks etc.) will be met with disappointment. Oh yeah, and then there’s the taper…

  15. BuildingCom says:

    Bear? Bull? Seriously? They’re meaningless and irrelevant terms at this point given the massive global credit bubble and resultant housing bubble that’s now just beginning to correct.

    The operative question is; Would you buy bonds (or lend money) in the current environment?

  16. Poqit says:

    Nothing particularly surprising has happened in a while. Something eventually will.

  17. Hutch says:

    For me, it’s that the interest rates on the 10 year have finally reached the level of some of the “interest alternative” dividend plays that have rocketed in the last few years, like $PG, & $CLX.

    But, I think that will take a while to really play out.

  18. Veneziano says:

    A responce via Crestmont Research in two charts.

    Of course, that doesn’t say when the market will enter Bearville, just that it is overvalued.

    - Jeff

  19. AGORACOM says:

    It’s all artificial. Therefore, it’s all overvalued. However, this artificial sea of liquidity could go on for years before the inevitable. OTOH, it could be tomorrow.

    Either way,artificial = overvalued = bear.

  20. davebarnes says:

    This is easy.
    IRS targeting
    terrorist fist bumps

  21. Bearbanker says:

    My primary indicator is Alan Greenspan. He says we are not in a bubble. And he missed the last three bubbles.

  22. Petey Wheatstraw says:

    We haven’t fixed anything. We have papered over past losses, and allowed the criminality that led up to them to continue, unabated. Out of sight, out of mind.

    No prosecutions. No new regulations of substance. No enforcement of existing laws and regulations. No liquidation of underwater assets. No new jobs. No increased incomes for the middle class. No potential income for millions of young people, educated or not.



  23. mfu5324 says:

    When the current administration (ok … when all of DC) gives the order for it to happen. Looking back the past 5 years, EVERYTHING in washington was done during crisis, last minute, shutdowns, crisis, did I say crisis yet?

    The folks in DC developed huge egos IMHO during the 08 crisis… they miss being treated like gods and begged to give them tarp etc etc…. They tried to talk the market down this past summer, but it didn’t work……they got stuff done last minute 2011… mini crisis…

    So as we enter 2014, a very large piece of legislation with our presidents name sake on it, looks like it will be an utter failure and total chaos…. and as the year goes on, more and more problems will brew with the ACA….. so, how do you get peoples minds off this bag of shit legislation …. Declare war? Nah….

    How bout drop the Dow to 8,500, have big lips Maria show up live on Sunday evenings again, have the Sunday talk shows stacked with CNBC anchors as guests….. etc. You drop the Dow to 8,500, I promise you people wont be talking about healthcare, and as a bonus, the lords in Washington will be able to con us American’s (again) into another trillion dollar stimulus plan to SAVE US ALL…

    So my prediction, 10% pullback in Feb, 20% rebound by April 15th (to get the IRA Contributions), then the order goes out to Mrs Yellen… and wha la… a repeat summer of 2008… it will brew leading up to the nov elections… which, by August a new stimulus will be passed, and Santa will promise his goodies to get votes…. they will forgive student debt (for the young vote), they will legalize anyone with a Spanish name (get the latinos), they will bail out pension funds for unions and blue states (get the union vote) and pass a law that women never have to pay for college again :) (a little humor in that one)

  24. pirannia says:

    In my opinion the next crisis will have a political trigger, not an economical one. There is an argument to be made that the last crisis was also an effect of political inaction, but next time I fear a radical political action bringing down one or more existing house of cards, healthcare being my favorite candidate, followed closely by high education tuition. I keep reading about towns where hospital X or university Y are the largest employers. Are we trusting our politicians with the task to orderly deflate these bubbles?

  25. Captin7Seas says:

    I am an optimist to begin with so a Bull by nature – but what has passed for sound fiscal policy out of WDC has been more bull than not lately (actually my whole life) and what has occurred in terms of economic recover has occurred despite their policy or intervention. My concern that I don’t think the current market reflects is by any measure this country is already bankrupt – by some measures like the GDP vs debt equation. Of course that does not consider the value of assets the gvt. owns – but how do you treat assets you print money to buy? QE to me must slow and stop but best case they likely will own what they bought to maturity because the increase in rates just from slowing purchases will increase our own debt serve costs so substantially, let alone trying to unwind those positions. In the private sector the impact to the bottom line will likely be to erase any improvements in profit that occurred mostly from lower borrowing costs and not from increases in sales or production efficiency. We have all seen the swift punitive reaction in the market when earnings are off expectations and when companies like Intel or Cisco try and manage forward earnings disappointments. When that occurs across multiple industries at the same time – the only possible result is a broad retreat from current levels. Either way QE needs to stop – it is only possible to print money to buy your own debt because we are still the worlds reserve country. If we do not protect that status we will be no better than the European Union, whose currency has been outstripping ours in value lately, which to me is a precursor next year their market will out pace ours. Its time we took some tough medicine in this country – just don’t know if our politicians will have the backbone to do it this time. If past history is any guide the answer is obvious – so the markets will self correct from an increasing impact from bankrupt policy if not from actual results on the world stage.

  26. Moss says:

    Any bear theme must begin with the Fed and the taper of asset purchases. Lets face it, the Fed balance sheet expansion, coupled with all the other Central Banks activities, have allowed conventional metrics to be used in valuating the Stock Market. (P/E, Profitability etc.) Volatility has been erased, Gold discredited, rates keep exceptionally low. It will all come down to interest rates as some point.

  27. BennyProfane says:

    I just came back from a rare Europe trip, flying in and out of JFK. The drive back to Westchester on the Van Wyck was depressing. All of this money spent, this so called “stimulus”, and the highway that 90% percent of Europeans see as their first example of American roads is an embarrassment, because we can’t seem to find a dime for infrastructure, instead of feeding the banker’s greed and floating a ridiculously overpriced housing market in most areas.

    So, what am I saying? Sure, times are good to OK for many, but, if we don’t get our act together, we are just going to continue this slow decline. Detroit will just be the first.

  28. igoru says:

    1) Profit margins are extremely high relative to historical levels and they have tendency to revert to mean (

    2) Shrinking government deficits caused by gridlock in Washington will lead to lower earnings (

    3) Banks and non-financial corporations in US benefited by 460 billion $ since because of QE and ultra-low interest rates (

    4) Because of falling unemployment Fed will begin to slow down with its purchases of bonds and that will lead to higher interest rates thus reducing earnings per point above.

    5) Falling unemployment will simultaneously lead to grater wage pressures, leading to smaller profit margins and grater inflation pressures. Latter will increase willingness of Fed to tighten and increase negative effects on earnings.

    In conclusion, since at this level of earnings and profit margins stocks are no longer cheap with coming headwinds for earnings they will become very overvalued and ripe for major correction.

    P.S. Extreme bear case would be if major correction happens, Fed again eases and easing has no effect. I think that all hell would break lose… but lets hope that is not going to happen.

  29. louiswi says:

    Barry, if you are going to write a column on this subject, it seems a clear look at financial and political history for the last couple hundred years is warranted. During that period everything conceivable happened (the end of the world excluded). I’m talking about financial calamities, wars, currency debasement, inflation, deflation, presidential assassinations, etc etc. Two things seem clear to me in terms of the market. Don’t fight the fed (good for the last hundred years and still valid today). And, the trend is your friend. Any prognostications currently coming from the noise machines seems to be mental masturbation. IMHO.

  30. Clem Stone says:

    The fractals of the hypotenuse are indicating a clearly negative vibration. Other than that, I got nothin’.

  31. Keith R says:

    Current valuations include two multi-generational outliers: low long term rates and high corporate profits as % of GDP. The market requires both to retains its valuation.

    Here is my general guesswork on how things might play out regarding these two inputs–

    1. Economy accelerates, and unemployment drops. Wages rise so corporate profits stagnate in spite of higher growth. Fed allows rates to drift upwards. The higher rates leave market open to break similar to 1987. (30% probability)

    2. Economy decelerates, and unemployment increases. Fed maintains bond buying to lower rates, but the FED and federal government have few options for stimulus. Long term rates fall, but profits fall faster. Market falls. (25% probability)

    3. Economy muddles along and Fed keeps buying program largely intact. Corporate profits muddle forward. Market move higher. (25% probability)

    4. Crisis appears from somewhere. Extreme version of #2. Market falls hard. (5% probability)

    5. Something else happens and market goes up or down. (10% probability)

    Much of my thinking is based on the belief that the Fed and Federal government have kept monetary and fiscal stimulus going for too long. This has pushed asset prices higher than otherwise expected and also left the government with few tools to avert a recession if it occurs.

    • Thanks — I appreciate your thought reply

    • Anonymous Jones says:

      I agree with a large part of this analysis, but there is one outlier in the last paragraph that I think might otherwise be missed in such a thoughtful discussion, and I just can’t let it go.

      On what basis or metrics could you say that “fiscal stimulus” has gone on too long? I didn’t even realize it was going “on”.

      I mean, there was a small *federal* fiscal stimulus a few years ago, but that was mostly offset by state and local government cutbacks. I see almost no reason to think that fiscal stimulus would be unavailable to fight a recession. Further, redistribution from savers to spenders could also fight a new recession, and very little of that has been implemented either.

      (of course, both fiscal stimulus and redistribution are in fact unlikely to occur for political reasons, but that’s a wholly different argument than one stating that current “fiscal stimulus” has gone on “too long”)

  32. polit2k says:

    All you need to know: The Hubble bubble theory of the continuous expansion of the financial universe | FT Alphaville by @izakaminska #ftt

  33. Molesworth says:

    I could have the lamest case of all. It is causation without correlation.
    Greenspan appointed Aug 1987. Black Monday Oct 1987.
    Bernanke appointed Feb 2006. Great Recession Dec 2007.
    Yellen appoint Feb 2014. Something bad happens to the market by Dec 2015?

  34. mllange says:

    According to Karl Denniger we are currently at higher valuations compared against assets less corporate credit liabilities now than we were in either 2000 or 2007. (

  35. Comstock says:

    Summary–Why We Are Still Bearish

    The following comment brings together in one article the various themes we have been writing about weekly, and emphasizes why we are maintaining our bearish position at a time when so many bears have thrown in the towel.

    The market continues to rise solely on the perception that the Fed’s easy money policy can hold stock prices up indefinitely. We think that this line of thinking will prove to be no more durable than the dot-com bubble that peaked in early 2000 or the housing bubble that topped out in late 2007. In both cases the market gave back a large proportion of the gains made during the bull market, and we believe that will prove to be the case this time as well. When the vast majority of investors faithfully believe in a concept, no matter how faulty it may be, momentum takes over and the market goes up because it’s going up, ignoring all of the obvious warnings such as high valuations, over bullishness, decreasing earnings momentum and an underperforming economy. When reality suddenly sets in, as it inevitably does, most investors are left holding the bag, hoping that the market doesn’t go any lower.

    The housing boom market of 2006 and 2007 provides the most recent example of the persistence of bullish momentum and irrational belief in the face of obvious negative events that were ignored in the frenzy to join the bullish crowd. As early as August 2006, various mortgage lenders began to go public with their dire problems. H&R Block’s subprime lending facility had to set aside $60 million due to borrowers falling behind in payments. Countrywide Financial publically stated that customers were slow in paying their loans. Similar statements were made by mortgage lenders Impac Mortgage and Accredited Home Lenders. Washington Mutual revealed that, as a result of improper calculations, it had made loans to borrowers at lower rates than their personal situation justified. The unpaid balance of these borrowers was $30 billion. It shouldn’t have taken much imagination to realize that these revelations were only the tip of the iceberg, and that there was much more to come.

    Now remember, the above revelations occurred in August 2006. The stock market kept rising for another 14 months to October 9, 2007. During these 14 months, new revelations came out almost daily, detailing the full implications of the crisis that was enveloping us. We learned how mortgages were sold and packaged, sliced and diced, and sold all over the world. We learned about an alphabet soup of various types of securities few had ever heard of before. On February 8, 2007, a Wall Street Journal article stated that “The mortgage market in the U.S. is a complicated web of mutually dependent businesses. Mortgages are bought and sold several times over, and the default risk often lands far from the institution that originated the mortgage.” The press was full of announcements of mortgage companies taking huge write-downs and going out of business.

    Things got even worse in June 2007, when two big Bear Stearns hedge funds came close to collapse. Despite all this, Wall Street still didn’t get it. As late as August 2007, a guest on financial TV casually referred to the turmoil as “financial gamesmanship”, as opposed to what he termed “solid economic fundamentals”. He was far from alone in his thinking, as the market rallied for another two months before peaking.

    Looking back, the market not only ignored the early warnings of some very prominent people and institutions, but, even when faced with the reality of events, continued to operate in a state of denial.

    The current market delusion is not about the dot-coms of 1999-2000 or the housing boom of 2006-2007, but about the blind faith in the ability of the Fed to hold up the market for an indefinite period in the face of a faltering U.S. economy, global weakness, decelerating earnings gains, significant overvaluation, overly bullish sentiment and the dysfunction in Washington. Although the bulls, as usual, say “this time it’s different”, there is nothing new in the market’s historical cycles between greed and fear. In the end, there is only the same old excess speculation in a new guise.

    Some market observers maintain that all of the talk we hear about a “bubble” means that we aren’t in one. However, we would ignore all of the talk on Wall Street and in the media about whether the stock market is in a bubble. After all, that’s just a matter of semantics, and whatever we call it, the market is overvalued, overbought, and overly bullish at a time when the economy is slogging along at an inadequate pace, and depends almost solely on the prospect of continuing Quantitative Easing (QE) to continue its upward move.

    The market doesn’t have to be in a bubble in order for it to be on the precipice of a significant decline. Of all the cyclical market peaks since 1929, only the tops in 2000 and 2007 were looked back on as being bubbles. Most of the other major market peaks occurred with the P/E ratio ranging between 18 and 21 times reported cyclically-smoothed GAAP earnings, compared to a norm of 15 times and bear market lows between 7 and 10 times. The current P/E ratio of 20.6 times earnings is high enough to be a potential market top, especially given existing fundamental and technical conditions. The similarity between now and 2000 or 2007 is not necessarily that we are in a bubble, but that the reason for market strength rests on such dubious grounds.

    In our view, the market is not supported by strong fundamentals. The so-called strength in the economy is based on forecasts, rather than on current conditions. But forecasts have now been overly optimistic for the last three years, and we see no change in the period ahead. The revised 3rd quarter GDP growth of 3.6% annualized is far from indicative of renewed economic strength as 1.7% was accounted for by increased inventories, meaning that real final sales were only growing at a still tepid 1.9%. And even taking the top-line number at face value, GDP has been growing at only 1.8% over the past year.

    Similarly, both real consumer spending and real disposable income have been rising at a weak 1.8% rate—-and this with a powerful dose of QE. Core capital goods orders for October dropped 1.1%, and have now declined for three of the last four months. With the rise in mortgage rates, housing has also become a weak spot. October existing home sales were down 3%, while the pending sales index, which leads existing sales, indicates more declines ahead. With consumer spending, capital expenditures and housing accounting for over three-quarters of of the economy, the recovery is not likely to become self-sustaining for some time to come.

    While it is difficult to estimate what the rate of economic growth would have been without Quantitative Easing, it is clear that the vast amounts added to the Fed’s balance sheet have barely trickled into the real economy. The growth of the money supply has been relatively low compared to the amount of Fed bond purchases (the multiplier). In turn, the growth of the economy has not been proportionate to the increase in the money supply (velocity).

    Technical conditions also point to a vulnerable market. Breadth has been narrowing and did not confirm the recent new highs in the averages. Daily new stock highs peaked in May and recently have been trending lower. The Russell 2000 has been lagging the large-cap averages. Some speculative high-P/E momentum stocks have recently been hit hard. Investors Intelligence bulls have averaged a historically high 55% and bears 15% over the past four weeks, numbers indicative of market extremes. There are now fewer bears than at any time since 1987 and less than the lows at the 2000 and 2007 stock market peaks. Margin debt is at an all-time high. According to Vanguard, investors, as a group, have a 57% allocation to equities, an amount exceeded only twice in the last 20 years—-the late 1990s and prior to 2007-2009. All of these numbers belie the belief by many that most investors are still too pessimistic.

    All in all, we believe that the market is facing significant headwinds, and that a major decline is not far off. In our view, economic growth and corporate earnings will be highly disappointing in the period ahead and investors will drop the pretense that the Fed can fix everything that ails the economy, particularly with the continued dysfunction in Washington and a restrictive fiscal policy. We believe that the risk of a major decline in the stock market outweighs the limited potential rewards from current levels.