Sunday, October 11, 2015

Is it really a bubble? Fair dinkum, mate!

How can anyone really know if the stock market is overvalued or not?  Times change; numbers can be interpreted any number of ways or even be fudged; and some prognosticators are naturally pessimistic while others are optimistic.  Maybe the stock market is just fine, even if the yield is only 2%.  We've already had two bubble peaks that were followed by crashes in 2000 and 2007 - how could we possibly have a third bubble in less than two decades?

Australia, a country that is similar to the U.S. in many ways, can be thought of as a control group in an experiment, and Australia's stock market (All Ordinaries Index) is a nice baseline that we can compare with our S&P 500 Index.

(CLICK TO ENLARGE)

In this chart that spans from 1995 to 2015, we see three massive stock market rallies in the S&P 500, shown in red.  The first rally from 1995 to 2000 was the infamous dot-com bubble which deflated from 2000 to 2002.  The dot-com mania was a mostly American phenomenon centered in Silicon Valley and the NASDAQ stock market, and was sparked in part by low interest rates, particularly a Fed Funds rate of 3% throughout all of 1993.  Australia had neither the glitter of Silicon Valley nor the low interest rates (6% in 1993), and accordingly its stock market (blue) participated in neither the bubble nor the decline.

The second stock market bubble started in 2003 while the S&P was still above the level of Australia's index.  In an effort to cushion the blow from the dot-com bust, the U.S. Federal Reserve set interest rates below 2% from January 2002 through mid-2004, while Australia's interest rate remained above 4%.  Unfortunately for Australia and the rest of the world, low U.S. interest rates encouraged the invention and exportation of sub-prime loans, mortgage-backed securities, and trillions of dollars worth of risky derivatives. Australian stocks, like stocks everywhere, eventually caught up with the U.S. in 2007 as part of the global financial bubble, which then burst in 2008.

Amazingly, at the end of the 2007-2009 bear market, and 14 years after the dot-com bubble began to inflate, the S&P 500 Index and All Ordinaries Index re-aligned.  As the above chart shows, both the S&P and Ordinaries gained about 70% from 1995 to 2009.  At some fundamental level it seems similar economies tend to grow at similar rates over the long haul, despite short term financial turbulence.

But getting back to the turbulence...

The Federal Reserve loves to lower interest rates after bubbles burst, and the bigger the bursting bubble is, the lower the Fed sets the rates afterwards.  As we now know, the entire global economy was in real danger in 2008, and central banks around the world took drastic steps to keep private banks, corporations and countries from going bankrupt.  In December 2008 the Fed lowered interest rates to below 0.25% ... and it hasn't raised them since then.  In addition the Fed has been making trillions of dollars of cash available for banks to borrow in a never-ending series of maneuvers called "Quantitative Easing".  Not surprisingly, the even lower interest rates over an even longer period of time coupled with money printing have fueled another huge rally in U.S. stocks.  Thanks to the Australian stock market, which is dealing with relatively large 2% interest rates and relatively little money printing, we can safely draw the conclusion that yes, we are indeed in a third stock market bubble here in the U.S.

(CLICK TO ENLARGE)

Since early 2010 the S&P 500 has gained 80% in value, while the All Ordinaries Index gained only 5%.  Dividend yields provide further evidence of the discrepancy: the iShares Australia ETF (ticker: EWA) has a whopping 6.9% dividend yield, compared to the paltry 2.1% yield of the SPDR S&P 500 ETF (SPY).

With no other information at hand, there is one play on this Yankee-Aussie split that is likely to win in the long run: betting on the S&P and Ordinaries to meet up again at their long-term trend like they did in 2009.  Equal investments in the U.S. bear market ETF (HDGE) and the Australia ETF (EWA) would result in a net return as long as U.S. stocks and Aussie stocks move back together.  This could happen if Australian stocks rise, but more likely U.S. stocks are poised to fall soon, and they would have to fall about 50% to return to today's Australian market level.  (HDGE would gain ~50%.)  As a bonus, if the U.S. dollar collapses in value relative to the Australian dollar, which is likely to happen if the Fed keeps printing money, then Australian stocks will make gains for American investors simply from the moving exchange rate.

In place of the Australia-only ETF I'm actually going to use Pacific ex-Japan ETFs (EPP, DVYA), which also include stocks from the relatively healthy economies of New Zealand, Hong Kong and Singapore, as the bullish counterbalance to HDGE.

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