The famous economist John Maynard Keynes recognized long ago that markets can deviate from their fundamental value for an extended period. His insight applies to U.S. equities today. As measured by the S&P 500, the broad-based market trades well above the historical average according to the 10-year cyclically adjusted P/E ratio. Stocks have been only before the 1929 and 2000 crashes more expensive than today.
Equities had an impressive bull run over the past decade. The Nasdaq 100 returned almost 20% p.a. That’s more than double the typical long-term total return that academics calculated from hundreds of years of cross-market data. Today’s market action is even more impressive if we put it into a historical perspective. The chart below compares today’s tech bull run to the stock market in the roaring twenties. Fears of excessive speculation by the Federal Reserve caused the Wall Street Crash of 1929 according to Wikipedia. The roaring twenties bull cycle lasted slightly less than 100 months and is depicted by the black time series. The period is iconic for a decade of wealth and excess. However, it looks pale and boring next to the Nasdaq 100 during the past decade.
Excessive speculation is not an artifact of the past. It is among the major drivers of the rally this year. The chart below shows the amount of premium spent by retail traders on call options into the September selloff. Call options are among the most speculative investment vehicles and their demand skyrocketed during this year. The development is clear evidence for elevated risk-inclination among investors. Speculative bubbles can get quite exciting but are not sustainable. Fundamentals are not favorable for long-term investors. Valuations are expensive and speculators fed the rally from the March low. Most likely, we’re witnessing how an asset bubble forms in U.S. equities. However, a bubble forming is not the same as a bubble bursting as Mr. Keynes recognized long ago. Expensive valuations and a stretched cycle persisted for months already. Moreover, the fundamental data discussed above hints at a bubble but cannot signal that it bursts anytime soon.
Technicals Signal More Upside
Most often, technicals have a better grip on the short-term time frame. The charts signal an intact upside trend from the March 2020 bottom. It subdivides into a sharp initial rebound that lost steam and trended up slower since mid-May. Most recently, U.S. equities rallied on strong breadth and attempted to recover from the September selloff. Small caps and banks outperformed relatively during the past few days. The Dow Transports index retraced the most recent selloff entirely and reached an all-time high yesterday. Technicals hint to buyer demand and not a fading rally. The upside trend remains intact as long as 3,150 does not break sustainably on the S&P 500.
Investment Strategy Depends On Personal Objectives
The observations discussed above hint to a bubble formation in U.S. equities. However, the bubble can and is likely to inflate further during the coming weeks. Speculative long positions will probably profit short term. Long swing and position traders might want to hold on to their position. Nonetheless, those who cannot closely monitor the market remain best off on the sidelines. There will be attractive buying opportunities during the coming years and it remains most reasonable to preserve capital.