by /u/spontaneousdisorder on Reddit

Over the last year US stocks have been rallying with greater and greater persistence and historic low volatility. This has been from already extremely high valuations. US stocks may be making a blow-off top and therefor could crash soon.

Today's financial environment is not exactly normal. We have been on the receiving end of a century long experiment that started with gold backed government notes and ended with a manipulated debt based financial system. In order to keep the house of cards standing interest rates have been brought to impossibly low levels (negative in many instances).

The end of a stock market bubble will have wider repercussions and with interest rates already at record lows (giving little scope for stimulus) it should take the debt structure with it — as was threatened by the 2008 financial crisis. It looks like this 20 year mania period is coming to an end.

Nasdaq (blue) S&P (Purple) Dow (green)

A variety of conditions make this top more risky than 2007 or even 1929. First we will look at the stock market, which in 2017 became the focus of a historic mania (along with bitcoin).

US stock valuations are the highest ever according to John Hussman’s margin-adjusted CAPE, which has a correlation of -0.89 with actual subsequent market returns.

This chart shows a slightly more accurate valuation measure. You can see the stock market relative to normal valuations from 1950.

See the latest chart for this indicator here

Markets top on optimism and bottom on pessimism, because it reflects investors tendency to speculate in those markets. Optimism in the stock market has been similar to or greater than every previous extreme, such as 1987, 2000, 2007 and 2014.

Investors intelligence recently hit the most extreme readings since before the 1987 crash. During large parts of the bull market optimism has been extreme according to this measure.

The next chart shows investors stock allocation relative to cash, which has surged to the highest since the dot com mania.

Rydex offers investors funds which allow them to invest bullishly or bearishly, the ratio of both gives us insight into investor psychology. The bear/bull ratio has hit a record low.

Margin debt in the stock market has also hit greater extremes for a much longer period of time than the prior 2 cycles (chart adjusted for inflation).

In January the daily sentiment index hit 96% bulls in the S&P and the 5 day moving average hit 92% which is a record in its 31 year history. Nasdaq hit a record 97% dsi (data started in 2000 for the Nasdaq).

chart from hedgefundtelemetry

Additionally moving averages of the put/call ratio have been hitting the lowest levels since 2014 as investors abandon hedges against a market decline.

Some of the above sentiment measures and a few more are summed into the “NDR crowd sentiment poll”, shown here at a record (since 1973).

Also the volatility index (VIX) as been at extremely low levels for months and months indicating complacency. One illustration of this low calmness is the number of days without 2 consecutive 0.25% loses.

These indicators and many more like them, along with breathless euphoria (“Signs of Euphoria Are So High Investors Are ‘Having a Hard Time Imagining a Decline”) in the media show the stock market is in the late stages of the bull or at the peak.

Previous tops have featured some of the conditions of this one, but this top creates some sort of record for its bad technical condition. It features the valuations of 2000 or 1929, a parabolic arc like the Nasdaq dot com bubble but with the calmness of the mid 60's and optimism like a bad combination of 1987, 2000 and 2007.

Deviations of stock prices from fair valuation are well correlated with consumer confidence. So it comes as no surprise that both are extremity high as the same time. This is because shared social mood determines the character of peoples behavior.

Since consumers are also extremely confident that reflects in their spending choices — they are choosing to save little money.

Savings have fallen since this chart was made

Debt has become an even bigger problem than 2007. Especially in Chinese debt, corporate debt, government debt and unsecured consumer debt (auto, student etc). Here is a chart of US debt — spot the financial crisis?

Consumer debt excluding mortgages is even higher than in 2007.

Debt quality is the lowest ever, corporate debt protection (covenants) have largely disappeared and issuance of junk bonds has exploded.

The junk “high yield” debt market:

Overall corporate bond issuance is easily at record levels:

Its not just the quality and quantity of debt, bond prices are the highest ever the world over, regardless of quality.

Despite the housing bubble being a distant memory house prices are high and the highest ever in many well off areas and major cities thanks to low interest rates on mortgages and the hunt for yield.

Governments not only racked up huge debts after the crisis but resist balancing their budgets, leaving them vulnerable to the next crisis (and with Republicans tax cuts a ticking time bomb has been created).

Pensions are one of the most dangerous financial structures out there. Whether public or private they are underfunded due to unrealistic expected rates of return, especially in a low yield environment. The depth of the problem is masked by high asset prices. So pension funds are going to receive a knockout blow in the coming years.

Economic growth has been reliant on increased employment, productivity improvements have almost ground to a halt and so growth has fallen with little potential for improvement.

Chart: John Hussman

In cryptocurrencies there has been a mania in a vast array of mostly worthless digital tokens. Objectively in some cases, the Tezos ICO is classified as a donation. Block One tokens “do not have any rights, uses, purpose, attributes, functionalities or features.”

Take for example this quote from the Financial Times:

TRON is now the 10th biggest cryptocurrency by market cap, at $10bn, with one unit trading at about $0.15. The team behind TRON has not released its working product, a decentralised entertainment system based on blockchain, the digital ledger technology that underpins bitcoin and other cryptocurrencies. But after a January 4 tweet from chief executive Justin Sun, claiming the start-up would soon announce a partnership with a “very prestigious public listed [sic] company”, TRON’s price more than doubled within 24 hours, hitting a high of 27 cents. Despite only launching last year, Dentacoin, which claims to be a “blockchain solution for the global dentistry industry”, has a $1.9bn market cap. It is not due to release its testnet, a blockchain used for testing, until the end of 2018.

Like the dot com bubble shares of any company announcing an involvement in crypto have shot up. Shares in Kodak rocketed 300% when Kodak “said it would launch the Kodakcoin, “a photocentric cryptocurrency to empower photographers and agencies to take greater control in image rights management.””

There was even a ponzi scheme called Bitconnect which reached a valuation of $2.6bn. It has subsequently been shut down. It may not be the last.

The total crypto market cap reached $820bn! Such phenomena can only occur at the biggest tops, when people are extremely predisposed to speculate. This also helps us recognize we must be close to the financial peak.

The US stock market is now the most overvalued in history, so is the bond market, both to the point of insanity. At one point there was over $10tn of negative yielding debt in the world (where the creditor pays the borrower). Investors are so ignorant of risk in the debt markets that European junk bonds yield no more than US Treasuries. During the financial crisis yields hit 18% and during the Euro crisis they were 9%.

Central banks have engaged in the biggest programs ever to buy massive quantities of bonds and even stocks. 0% interest rates have existed throughout the economic cycle (apart from the Feds slight increases recently) for the first time ever. What increases in interest rates could debtors possibly withstand after nearly a decade of rates cut to the floor?

The buildup of most of these conditions “stimulated” the economy, but there is no free lunch, 3 decades of debt binges will resolve in a crash that wipes out the unproductive debt that the system consists of (and thereby drives and distorts the economy). People will panic and try to recover whatever real value is left in our financial system and economy.

In the past bubbles such as the roaring 20s were associated with a shorter period of optimism, more modest asset bubbles (usually limited to a single asset class) and debt expansion that led to crashes and an economic depression (e.g. the great depression). So how concerned should we be about an era or rolling bubbles lasting over 20 years, involving almost every asset class at one stage or another, in some cases multiple times and a debt bubble many times greater than anything in history? So huge that interest rates have to be pushed to the floor to keep the structure from collapsing?

The bubble and crash a decade ago seemed dramatic but on most charts now its simply appears as a modest correction within a much larger mania. What does that say about the size of the overall bubble? Bailouts at the time prevented a deeper wipe-out of the unproductive debt.

The old analogy of a forest fire is a good one. By extinguishing small fires the tinder for a larger conflagration has built up. This environment has been created by a long period of complacency and optimism. Markets/institutions have not been exposed to even the slightest stress let alone full on fear and panic. That’s how a “goldilocks” economy in 2007 could turn into an inferno just a year later.

Money in today's system is credit, the flip side of debt. So your “savings” are really an obligation to pay you back sometime in the future. Multiply this by trillions and trillions of dollars in complex financial arrangements and you have today's financial system. This sort of structure may work well in expansion, when more money seemingly creates more money. But when the system reverses into contraction, such as in 2008, one implosion quickly leads to another until the system buckles.

Such an implosion is deflationary because the value of assets and bonds collapse, the ability to access money from institutions can become curtailed and people become more conservative in their spending behavior. Some people think central banks can generate inflation and avert a crisis even after the 2008 crash in financial markets. Japan has been unable to generate inflation despite extraordinary levels of quantitative easing. My guess is their actions will contribute to the downside potential.

Where should you put your money to avoid an implosion?

What about a traditional safe haven —government bonds. Well they have spent the last 35 years in a bull market to the highest prices (lowest yields) in history. Governments are burdened with debt to historic levels and in Europe yields were pushed even to negative levels. Prices have large downside risk from here. So if you wanted to be in safe government debt, short maturities would remove most of that risk. Government bonds could benefit from an initial flight to safety but I would be concerned that the bull market is ending after investors have spent several years loving bonds (a typical sign of a top).

The bull market in the T-bond. Here the 2-year is racing toward the 10-year, note the yield curve inversions happen before recessions

What currencies will remain safe? The US dollar has been much maligned, especially just before the financial crisis where many people talked of dollar collapse and hyperinflation. The dollar setback this year led to talk of “dedollarization”, however “risk-off” periods like the financial crisis have been positive for the dollar in recent years. It’s no surprise the recent risk-on period has been bad for the dollar. I think it will have another substantial rally, however the secular bull market will be getting old by that point.

Here is the commitment of traders report for the Euro (which is essentially the inverse of the USD index). You can see similar data but for the USD in the chart above. As you can see speculators are record long the Euro and are usually wrong at major turns.

This is the daily sentiment index for the dollar, traders have become very bearish.

Oil tends to move opposite to the dollar and the setup in oil is compatible with a dollar rally. Speculators have a clear record bet on increasing prices, whereas commercials are hedging in those high prices. Another crash in oil would fit with a deflationary economic contraction.

…and the daily sentiment index for oil, which has reached greater extremes than before the collapse that began in 2014.

Since this bear market could be fraught with counter party risk there can be value in owning your own house and/or some physical gold. Gold did OK during the financial crisis, however this was in the middle of a large bull market. I think it is probably still in a secular bear now and that will resume with the crash, however gold is not as overbought as most assets today. You could keep the option of using gold as an escape vehicle when things get sketchy or just own some in advance.

Given the systemic risk and potential for deflation it would be a good idea to have cash or cash like instruments, held in safe forms. Being ready to obtain physical cash if the situation arises would be helpful, or have some in advance, perhaps in US dollars and/or local currency. If there are systemic failures in the financial system then it could be very deflationary. Risk off periods in recent years have been dis-inflationary or deflationary but people often emphasize the risk of inflation perhaps because of the 70s, or the preceding century of inflationary central bank policies.

Many people wonder what could “trigger” the next crisis. Since there is little evidence of deterioration in financial markets right now (like in 2007) I think the kickoff may be a stock market crash given how historically calm, over-bullish, overbought and overvalued the US stock market is and its almost vertical ascent. This could extend to some other assets that are extremely overbought such as Oil, the Euro and perhaps the bond market (at least the lower quality stuff). The dollar should rally.

As the stock market falls it will be the leading indicator of the severity of the crisis (along with perhaps the credit markets). A fall of 20%+ may indicate a mild recession, beyond 40% and a severe recession with large institutional failures would become more likely. You can check individual stock prices to get an early warning of what companies might be failing (useful for your banking, employer or other institutions you rely on). Make a plan of what actions you may need to take. How would you move or withdraw cash and buy hard assets if need be? What institutions might provide safe storage?

Stock prices provided an early warning of Carillion’s failure

The last 20 years have seen nearly relentless optimism that has driven asset prices into the stratosphere and a debt binge unlike anything in history. We are now at the peak of the 3rd mania in succession. The debt based financial system has been extended beyond credibility. Stay safe :)