by Jim Rickards, DailyReckoning:
Whenever stocks rise sharply for a sustained period, or rise more than a few days or weeks in a row, as had been the case until these past few days, there is always some pundit quick to label the trend a “bubble” and advise investors to run for the exits.
Usually the pundits are wrong. Most so-called bubbles are not bubbles at all, they’re just short-term trends driven by sentiment or momentum. Those trends may slow down or even reverse, but they don’t burst catastrophically the way real bubbles do.
So pundits who yell “bubble” too often are marginalized as doom-and-gloomers, perma-bears, or the boy who cried wolf.
Yet bubbles are real.
They do burst suddenly and catastrophically, and most investors do lose fortunes when they burst. The art of analysis consists of recognizing the difference between real bubbles and mere short-term trends.
My job is to use the right tools to spot real bubbles, and warn readers in time to avoid losses and even make gains as markets are crashing.
U.S. equity markets today are flashing red when it comes to bubble potential.
True bubbles happen for a variety of fundamental and psychological reasons. Below are two of the most famous stock charts in history.
Chart 1 traces the Japanese stock bubble of 1983 to 1989, which resulted in a spectacular collapse of the Nikkei 225 Index beginning on January 1, 1990.
Famously, that Japanese bubble included real estate as well as stocks. In 1989, the land inside the Imperial Palace Walls in central Tokyo (a three-mile circumference) was said to be worth more than all the land in California.
At the end of Japan’s lost decade, the Nikkei Index stood almost 75% below the peak it reached in late 1989.
Chart 2 is the U.S. stock bubble of the “Roaring Twenties” as shown in the Dow Jones Industrial Average. That crash began on October 24, 1929 (“Black Thursday”) and reached a crescendo on October 29, 1929 (“Black Tuesday”).
The 1929 crash ushered in the Great Depression, which persisted until 1940. At the lows, the Dow Jones index had fallen more than 85% from the 1929 high. Stocks did not recover their pre-crash levels until 1954, a full quarter-century after the crash.
The bubble dynamics are easily seen from these charts. Bubbles do not emerge from depressed conditions or prior collapse. The memories of prior losses are usually enough to prevent investors from engaging in bubble behavior.
Instead, bubbles follow periods of growth and persistent stock market gains. The original stock gains are based on fundamentals. Japan in the 1980s and the U.S. in the 1920s were both highly productive and fast-growing economies. Stock market gains made perfect sense.
Bubbles emerge at the end of long expansions when memories of the last crash fade, and euphoria replaces common sense. At that stage, the slope of the market index curve steepens at an accelerating rate.
The chart no longer rises gently; it rises vertically in a hyperbolic fashion. The result is the famous “hockey stick” image of a gently sloping base with a steeply sloping handle. That is visible in both Chart 1 and Chart 2.
The other characteristic of bubbles is that they persist much longer than many observers expect. It would have been easy (and not wrong) to yell, “bubble” in the U.S. in late 1928 or in Japan in late 1988. Yet markets powered higher despite the warnings. Those who issue early warnings are regarded as cranks. Those who short the market too soon can lose their shirts. Yet, those issuing warnings ultimately proved correct.
The Dow is up over 25% and the S&P 500 is up over 20% over the past year. More than half the gains for both indices were realized in the 3 ½ months since Donald Trump’s election as president:
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