Paul B. Farrel: 10 Peaking Megabubbles Signal Impending Stock Crash http://investment

By Paul B. Farrell, MarketWatch

Yes, “the bull market may come to an end any time,” warns Jeremy Grantham, founder of the $117 billion GMO investment giant. An unpredictable collapse. Risky valuations, 10 bubbles peaking, and black swan megatrends: The bull “could be derailed by disappointing global growth, profits sagging as deficits are cut, a Russian miscalculation, or, perhaps most dangerous and likely, an extreme Chinese slowdown.”

Yes, Grantham’s hedging his near-term: Betting the S&P 500 could rally past 2,250 before the 2016 presidential election, “depending on what new ammunition the Fed can dig up.” But then, a black swan will ignite “around the election or soon after, the market bubble will burst” and “revert to its trend value, around half of its peak or worse.”

Yes half. The S&P 500 will collapse to about 1,125. This Fed-driven rally “will end badly.” Repeating the dot-com losses of 2000-2003. Repeating Wall Street’s $10 trillion losses in 2007-2009.

Another GMO investment strategist, Edward Chancellor, is even more skeptical of all these explosive short-term risks. An expert in speculative bubble risks, Chancellor warns investors of a ticking time bomb. His team tracks market bubbles. They’re feeding off one another, gaining momentum, fusing, expanding into a dangerous critical mass that can trigger and ignite an S&P 500 explosion way before the 2016 elections.

“It is important for the Fed, as hard as it is, to try to detect asset bubbles when they are forming,” Fed boss Janet Yellen told the Senate last fall. Then two months ago, Yellen said she didn’t see any speculative “excesses,” that stocks were in line with “analysts estimates of future earnings.” Bad news, Chancellor warns, future earnings are a “notoriously unreliable measure of market value.” Besides, everyone knows the Fed is has big “trouble identifying bubbles.”

New megabubbles bigger than ‘20s Gilded Age and ‘90s dot-com mania

While the Fed hesitates, GMO is clear. Why? The formula is simple: “When an asset has moved two standard deviations from its long-term real price trend” the markets are in a bubble. That fits “the 1929 bubble, the Nifty-Fifty boom of the 1960s, and the dot-com mania in the late 1990s.”

So Chancellor reviews the “typical features of asset bubbles” throughout history, concluding “most of the conditions under which earlier bubbles have appeared are present in the U.S. markets today,” including “the soaring performance of IPOs.” Long-term stock investors beware.

In short, despite Wall Street’s relentless happy talk and optimism, another crash is dead ahead. A crash that may be as devastating to America as the 1929 Crash, the Sixties Nifty-Fifty boom, the dot-com crash of 2000 preceding a 30-month recession, and $10 trillion market losses in the 2008 bank-credit collapse.

Here are the 10 high-risk bubbles GMO sees as warning signals that another costly crash is dead ahead:

1. This-time-is-never-different bubble

Throughout history, market mania is “rationalized with the argument that history is no longer a reliable guide to the future.” In the 1920s it was a “new era.” In the ‘90s a “new paradigm.” Today Wall Street’s doing it again: “U.S. profit margins are currently at peak levels and the profit share of GDP in the United States is more than two standard deviations above its long-term mean based on data going back to the 1920s.”

2. Moral-hazard bubble

“Speculative bubbles tend to form when market participants believe that financial risk has been underwritten by the authorities.” Remember the “Greenspan Put:” In the late 1990s Wall Street was convinced the “Fed would support falling markets.” Greenspan “wasn’t going to act against the bubble in technology stocks.” Fed policy hasn’t changed much, they “put a floor under asset prices, encouraging investors to take on more risk.” As a result, household wealth has “rebounded to a near-record level of 472% of GDP, nearly 100% above its long-term mean.” And today, banks still expect “perpetually low interest rates.”

3. Fed’s 24/7 easy-money bubble

Chancellor tells us: “Great speculative bubbles have generally been accompanied by periods of low interest rates.” For over a decade Greenspan’s policies “inflated the U.S. housing bubble.” Then after the 2008 banking collapse, Bernanke’s cure was “more of the same,” while “real interest rates have been maintained at negative levels.” In addition, quantitative easing kept long-term rates artificially low, inflating home prices and growth-stock valuations, further inflating high-risk asset bubbles.

4. Perpetual growth bubble

Back in the ‘90s dot-com bubble, tech stocks were experiencing rapid “S-curve” growth while investors were “encouraged to value the “real options” of Internet stocks from future income streams yet to be conceived. Same today. Hot stocks in social networking, electric cars, biotechnology, Internet, “have been boosted by similar wishful thinking.” Warning, throughout history, future earnings estimates kill future bubbles.

5. Zero-valuation asset bubbles

Since the 17th century Dutch tulip mania, “most speculative markets” have had no income to anchor a speculator’s imagination. Today’s electronic age makes it worse.Bitcoin “soared by 5,500%” in 2013. In fact, Chancellor warns most “recent stock market darlings — Netflix, Facebook, Tesla, and Twitter — have little or nothing in the way of profits.” Even with margins dropping, Amazon was up nearly 60% in 2013. It’s still “the poster child for a market more obsessed with growth than profitability.”

6. ‘Gilded Age’ bubble revival

Throughout history “asset price bubbles are associated with quick fortunes, rising inequality, and luxury spending booms,” warns Chancellor; excessive, out-of-control “conspicuous consumption.” Since the 2009 bottom, the art bubble, “evident before the financial crisis, has returned.” Example, a Jeff Koons “Balloon Dog” sculpture auctioned at $58 million, even though it was one of five he had made in a factory. “The same month, a painting by Francis Bacon sold for $142 million, the highest price ever paid for any work at auction.” Yes, the Gilded Age of the late ‘20s is back. More bad news.

7. New junk-bond-mania bubble

Another dangerous trend: “Manic markets are often marked by a decline in credit standards,” says Chancellor. The real estate bubble exploded Wall Street’s love of subprime mortgages, “but it hasn’t diminished the appetite for low quality U.S. credit.” Today investors are buying “the lowest yields for junk bonds in history.” Quality is deteriorating. “Last year, nearly two out of three corporate bond issues carried a junk rating.” Even Fed boss Yellen has “expressed concern about the manic leveraged loan market.”

8. ‘Irrational Exuberance’ bubble sequel

Yes, ‘90s “Irrational Exuberance” is roaring back: “Market sentiment have become very elevated over the past year.” The IPO market “has become particularly speculative.” First-day trading on new IPOs were up an average 20%. “Twitter rose 74% on the day it came to the market.” Yet, most of the recent IPOs not only had no profits, many, especially biotechs, haven’t “even got around to generating anything by way of revenue.”

9. Corporate-insider-trading bubble

“Other sentiment measures have been telling the same story” according to Chancellor’s GMO research team: Corporate insider trading, a “reasonably good indicator of management’s view on the intrinsic value of their companies” recently “climbed to near record levels.” Equity mutual funds “picked up lately.” And “margin debt as a share of GDP is close to its peak level.” All scary stuff.

10. Composite market sentiment index

GMO’s composite index of 20 sentiment indicators has “reached an extreme level, fast approaching two standard deviations above its long-run average.” Since the 1950s that extreme has only been exceeded twice, in 1968 during the “Great Garbage Market” and in the late ‘90s dot-com mania.

“Great bubbles tend to coincide with strong credit growth,” says Chancellor. So far that’s missing. We need it before a “full-blown stock market bubble,” and right now “the credit cycle is not close to a peak.” So unfortunately, the Fed will probably passively watch while a “full-blown stock market bubble” builds to critical mass.

In short, Yellen will do exactly what Greenspan and Bernanke did earlier … fail to plan ahead … passively endure more irrational exuberance mania … waiting for the ticking time bomb to blow up … before finally stepping in … cleaning up their mess … again … bailing out incompetent banks … while letting the taxpayers suffer through the third major crash this century… third recession … third megatrillion loss of Main Street’s retirement market cap.

But beware, while as yet GMOs market sentiment indicators don’t provide “a sure-fire signal that the U.S. stock market is about to collapse,” investors “shouldn’t take much comfort from this.” This cocktail of valuations, sentiment and global macro trends has been quite accurate in “forecasting future equity returns.”

Bottom line: “Anyone who bought U.S. stocks in the past when sentiment was at today’s elevated level, lost money.”

So prudent investors please listen, very, very closely: It doesn’t matter whether the markets crash or merely suffer a major correction, GMO is warning us the S&P 500 has a high probability of falling to “negative real returns over one-year, three-year, and seven-year periods.” And that sure sounds like another way of saying a major crash is dead ahead.

Paul B. Farrell is a MarketWatch columnist based in San Luis Obispo, Calif. Follow him on Twitter @MKTWFarrell.