Market mavens have increasingly turned their
talk to a possible “melt-up” scenario in the stock market. The big fear entering 2014 is that another
runaway freight train-type stock market, like the one preceding the 2008 crash,
is gathering momentum. The latest
comment by incoming Fed president Janet Yellen only added to that speculation.
Yellen stated last week
that, based on current valuations, stocks aren’t “in territory that suggest
bubble-like conditions.”
Her lack of concern is one reason for thinking that the equities could
be on the verge of a melt-up. Economist
Ed Yardeni has made the case for this potential scenario playing out,
especially if Yellen turns out to be more dovish than Bernanke as he expects.
There are two principle drivers
behind the melt-up scenario: the first is the so-called “reach for yield” among
investors that Yellen herself alluded to in her latest remarks and which has
resulted in a veritable bubble for corporate and emerging market debt issuance. The second is the unprecedented monetary
policy of the Fed in its frenzied efforts to beat deflation and lower
unemployment.
Emerging market debt
suffered a temporary setback in the wake of the “tapering” talk and debt
ceiling limit debate earlier this summer.
Since then, however, emerging market bonds have rebounded and there is a
growing conviction among savvy investors that this sector is precariously close
to being over-inflated. It’s not there
yet, but it appears to be headed in that direction and that’s one of the
potential catalysts to an early 2014 melt-up scenario.
Corporate bond issues have
risen to a record $6.1 trillion as of the second quarter of 2013, according to
Federal Reserve statistics. This
translates to an increase of $625 billion year over year. Moreover, as Yardeni points out, corporations
are likely using some of their bond sale proceeds to repurchase shares of their
companies, which artificially inflates earnings per share. “That’s a bubble-like development if stock
prices are getting a significant lift from
debt-financed share buybacks rather than actual earnings growth,” Yardeni
wrote.
But
short sellers beware: we’re not there yet.
The bubble vigilantes are out in full force which suggests a
full-fledged financial market bubble hasn’t fully developed. On the front cover of the latest issue of Barron’s, the editors ask the question
of whether or not equities are in a bubble.
Their answer: “Yes, in some tech names and new issues” and “No, in most
other shares.” The Barron’s cover very much underscores the heightened sensitivity to
developing bubbles, which in turn keeps investor sentiment from becoming too
ebullient before the final melt-up stage of the bull market.
Assuming the market does start melting up in
the coming weeks and months, the final outcome is easy enough to predict: a
market crash. The fact that the 120-year
cycle is in its final “hard down” phase next year would only add impetus to the
crash following a breath-taking rally to new highs. Accordingly, investors should prepare for
this possible scenario in 2014.
