The Stock Market: A Picture of Excess

More Ominous Charts

We have decided to expand a bit on our recent post about “ominous charts” and show a few more charts that should at least give one pause. We hasten to add that none of them should be seen as timing indicators. It must be stressed that we continue to be in unprecedented situation, with central banks worldwide cutting interest rates to the bone with policy rates in the major currency areas having been kept at or near zero for an unusually long time period.


roman-orgy-vasily-alexandrovich-kotarbinskyParty on dudes!

Painting by Vasily Alexandrovich Kotarbinsky


At the same time, central banks have actively printed money to replace the lack of credit expansion by commercial banks (resp. are continuing to do so), and not surprisingly they have proved quite adequate at this task. Most of this newly created money has flowed directly into securities markets. A few central banks such as the SNB and the BoJ are even buying stocks outright (the SNB e.g. holds a very large position in AAPL, among others). This mountain of newly created money keeps growing at an astonishing pace and is still rippling through the securities markets and the economy.

In light of this, many formerly tried and true indicators have seemingly ceased to provide us with any meaningful signals. However, we believe this has to be qualified a bit: the signals may not be meaningful in the short term, but they are likely to turn out to be of great long term significance. Right now, several important market sectors such as technology and financial stocks are in “break-out mode”, so from a technical perspective, one cannot yet sound the alarm, although we have been a bit surprised to find out that a number of prominent bears are saying the very same thing of late.

We cannot fault them for being well-trained by now; these are people who know the bubble will end in tears, but similar to Hugh Hendry of “blue pill” fame, they feel that their money management duties force them to respect technical break-outs, while keeping their eyes firmly trained on the exit door in the hope they will recognize the moment when the time to step through it has arrived, with their assets intact. Anyway, the upshot is that the charts below aren’t telling us when exactly the risk they depict will become manifest. All they are are saying is that the eventual denouement will likely be of stunning proportions, or putting it differently: risk is extremely high and growing by the day.

For starters, here is an update of the divergence in the Dow Industrial and Transportation Averages, which we recently discussed. Transportation stocks remain below the support line they recently broke, but in order for a Dow Theory sell signal to be given, the Industrial Average needs to break below its “equivalent” support level:

1-Indu-vs-TranThe Industrials Average needs to break below approx. 17,600 to create a Dow Theory sell signal. However, the long-lasting divergence between the two averages defnitely remains a warning sign of sorts – click to enlarge.

Today we want to show a few charts many of which are usually not receiving a lot of attention. The first one is an updated version of our Rydex asset charts. We only had to adapt the annotations slightly – the most noteworthy recent developments have been a further decline in bear assets to fresh record lows this year, as well as a decline in money market assets back to levels last seen in the 1990s.

2-RYDEXRydex assets and the SPX. From the top: Rydex money market assets, bear assets, and the pure bull/bear asset ratio. Rydex bears are becoming an extinct species, however, Charles Biederman of TrimTabs recently reported that there have been sizable inflows into bearish ETFs. The problem with these data is that it isn’t possible to tell who exactly bought these inverse ETFs, whereas in Rydex funds we can be pretty certain that they reflect the activities of retail traders.

Speaking of money market funds, here are two charts that compare investment in the stock market to assets held in money market funds. The first one, the equity/money market funds ratio, takes the total amounts invested in mutual funds and ETFs and compares them to the total amount invested in money market funds. The second chart shows retail money market funds divided by the market capitalization of the S&P 500. These are long term charts, which enables us to compare the situation at or near the beginning of the secular bull market (when stock market valuations were very low) to today’s situation.


3-Equity-money market assets ratioInvestment in equity mutual funds and ETFs compared to money market fund assets. Today this ratio is far more stretched than at the previous secular peaks, which were followed by two of the most severe bear markets of the past century – click to enlarge.

4-retail money market ratioThe retail money market ratio (retail money fund assets/SPX market cap) paints an even starker picture. There was a great deal of fear at the beginning of the secular bull market in 1982. The exact opposite is the case today (we suspect that apart from excessive money printing, this may be due to the popularity of Prozac and similar anxiety-suppressing drugs) – click to enlarge..

A chart we have actually frequently shown in the past is the mutual fund cash-to-assets ratio. Fund managers have altered their behavior dramatically over the past 30 to 35 years. Cash has truly become trash. Partly this is due to the fact that yields on “safe” near-cash investments are non-existent, and partly it is due to career considerations. Managers will be punished for missing a rally, but there will be no repercussions from being caught in a debacle with everybody else. Once again one can clearly see the stark difference between the situation at the beginning of the secular bull market in the early 1980s and today.

5-Mutual fund cashMutual fund cash ratio: currently just 10 basis points above an all time low, at 3.5% – click to enlarge.


The point of all these charts is to show how little regard there is for risk, and how little money most active market participants are actually keeping in reserve. This means that once a meaningful decline gets going, there won’t be much firepower available to arrest it or slow it down (although there is of course a huge amount of money in the economy these days, but there is no telling how current money holders will deploy it in the future).

Along similar lines, it is well known that margin debt has recently reached a new record high. This normally means that the market will continue to rise in the near term, as margin debt usually peaks out prior to major market tops. However, the sample size on this phenomenon is small and there can be no guarantee that it will work in the same manner every time, so we would take this information with a grain of salt. As a result, the negative credit balances in NYSE margin accounts have never been higher than they are today. Once again, this implies that once a decline gets going, these margin accounts can possibly deploy any additional buying power– on the contrary, they will turn into forced sellers, which will exacerbate the downturn.

6-NYSE available cashAvailable cash in brokerage accounts – or better said, non-existent cash in brokerage accounts – click to enlarge.

Doug Short publishes various charts related to margin debt, one of which shows margin debt and the SPX adjusted by CPI. The recent marginal new record high in margin debt attained in March this year can be seen on this chart:

7-NYSE-margin-debt-SPX-since-1995The SPX and NYSE margin debt, adjusted by CPI. Normally, margin debt tends to peak before the market does, but the sample size bearing this out is small. Moreover, since everybody “knows” this, it may no longer be true – click to enlarge.


Valuations and Big Investor Fears

It is well-known by now that the CAPE (cyclically adjusted P/E ratio), or Shiller P/E, is at a level that is only exceeded by the levels reached in 1929 and 2000. Once again we point you to Doug Short’s excellent overview of valuations in this context. Moreover, as we have mentioned on a number of occasions, the median stock has never been more expensive than today. There can be no doubt that valuations are excessive. John Hussmanattacks the faulty “Fed model” again this week (as we noted when we showed this chart of Japan’s stock market compared to interest rates, contingent circumstances can easily invalidate such models) and provides us with a different look at valuations, which we reproduce below.


8-wmc150525aVia John Hussman: the market cap of non-financial equities divided by gross value added, including foreign revenues. This measure indicates that the market is currently at the second most overvalued level of the entire post WW2 era – click to enlarge.

One question that suggest itself in view of such data is whether anybody is actually worried about this. When looking at the sentiment and positioning-related data points we have shown above, one might come to the conclusion that there is no concern at all. However, this isn’t quite true. One method of tracking a group of investors that is generally not regarded as a contrary indicator, is by looking at what is happening with options on the S&P 500. These options are quite expensive in absolute terms and not very popular with small traders and retail investors. However, they are used extensively for hedging purposes by big traders.

Some time ago CSFB has devised a “fear barometer” that shows what entering a zero-cost collar implies in terms of how far out of the money the protection is that can be theoretically bought at no cost by selling a specific call. Essentially this is a variation on the Ansbacher Index, as it compares the premiums paid on calls with those paid on puts – employing solely SPX options.

It works as follows: first it is determined how much one can receive by selling an SPX call expiring in three months time that is 10% out of the money. Then one searches for an SPX put that can be bought with the proceeds, or rather, one calculates how far out of the money this put is based on current premiums, i.e., by what percentage the SPX would have to decline for this put to become an at-the-money put (calculation is required, as neither a call strike that is precisely 10% out of the money nor a put option with an exactly similar price are likely to exist except for brief moments in time). The result is plotted as an index – i.e., the height of the index shows the above mentioned percentage. The higher the index, the more expensive SPX puts are relative to SPX calls. The index thus expresses the urgency with which big traders are seeking out protection against a sizable market decline.


9-Fear premiumThe CSFB fear barometer has been near record highs since mid 2014. Note how low it was at the depths of the 2007-2009 market decline – clearly, this is not a contrary indicator. Big traders are paying up for protection, a sign that they believe the market is very dangerous at current levels – click to enlarge.

Once again, this is obviously by no means a precise timing indicator. We are struck though by the persistence with which big traders have paid up for protective puts, resp., how reluctant option writers are to sell them. It will be interesting to see what happens if the market continues to rise. Our bet would be that in this case, the fear index will reach new all time highs. We observed the very same development in NDX jumbo options during the Q1 2000 blow-off in the Nasdaq Composite Index. NDX puts kept getting more expensive the higher the Nasdaq went. It was a strong sign that a denouement was not too far off.

The Biggest Red Flag Yet

A few days ago the very worst thing that could possibly happen to stock market bulls actually happened. According to an article at Zerohedge, the following news flashes came across the Bloomberg wires:



Given the former Fed chief’s well-known and often demonstrated utter cluelessness about asset mispricing, which he frequently displayed during the latter stages of the housing and mortgage credit bubble the Fed instigated between 2001 and 2007, the above information is undoubtedly a major red flag.

Once again, it is not an indicator that can be used for timing purposes, except perhaps in a very general manner (last time around, Bernanke’s lead time was roughly between 12 to 6 months relative to the stock market peak, but it was much shorter relative to the median home price peak – in fact, several of his utterances with respect to the housing bubble were made after the peak had been quietly recorded in mid 2006).

Apart from the fact that when Bernanke feels compelled to state that assets aren’t mispriced, we can be 100% certain that they are in fact egregiously mispriced, his second statement is likewise ludicrous. How is the Federal Reserve supposed to “manage” an asset price drop scenario? If it could magically keep crashes from happening, no crash would have happened in 2008, or at any other occasion since the Fed has been in business. The reality is that it has presided over the by far worst crashes and bear markets in all of history. There is nothing that can be “managed” – the errors that are committed due to its manipulation of interest rates and money supply growth cannot be “uncommitted” retroactively. When the inevitable moment of price adjustment arrives, it will happen regardless of what the central bank does at the time. Bernanke evidently suffers from the “potent directors delusion”.

In addition to this, Bernanke has quite likely also just ensured a severe hard landing for China and a recession in the US (for details see this Reuters article: “Bernanke sees no risk of hard landing in China, bullish on U.S. Economy”).   Maybe China’s Politburo should consider applying for a gag order to be imposed on Bernanke, otherwise China’s vaunted social harmony may soon be in serious trouble.


It is important to keep in mind that none of the data shown above mean that the stock market cannot rise further or that it will decline in the near future. It is unknowable how much more pronounced these excesses can become, especially in light of extremely loose monetary policy around the world. Things could easily become quite dicey as soon as tomorrow, but it is just as easily possible that valuations will continue to expand for some time yet. However, these data do indicate one thing: risk has increased enormously, and it will keep increasing the longer the bubble persists. We have said this before of course, but it is even more true today than it was then.

Frankly, the situation also scares us a bit, because we expect that governments and their agencies (such as central banks) will find it extremely difficult to deal with the next crisis. They have become quite overstretched as a result of the last one. After having gone “all in” last time around, what are they supposed to do for an encore? The only options that come to mind are repressive measures such as capital controls, confiscation of private wealth, and a host of other unpleasantries. Moreover, one must expect various radical political organizations to gain a lot of electoral support, as voters will rightly consider the establishment to have failed. This is danger is especially pronounced in Europe, where the free market has very few supporters to begin with, and the political class and its media mouthpieces are highly likely to once again blame non-existent “lassez faire capitalism” for the failures of socialistic central planning institutions.


Charts by: StockCharts, SentimenTrader, John Hussman, Doug Short / AdvisorPerspectives