Zeller Kern’s Investment Monitor

A Bubble In the Making?

October 11, 2017

By Steve Zeller

In what often brings volatility and turmoil within the stock market in the months of September and October, have, so far, proven otherwise. These two months have experienced very little volatility, and the S&P 500 and the Dow Jones Industrial Average have realized all-time highs. The S&P 500, as of Friday’s close, stands at 2549.33, and the Dow Jones Industrial Average stands at 22773.67.  The high for the S&P 500 was achieved on October 5th, when it closed at 2552.07, an all-time high.

It can be theorized as to why the market keeps pumping up as we move forward. A theory that includes a continuation of the “Trump Bump” in which investors continue to raise the stakes and pour money into the market because of the expected impacts of a corporate tax reform, which would potentially cause a massive boost to earnings from tax rate reductions as well as repatriated offshore cash, which in theory, would be used directly for stock buy backs. Although, that may be a disappointment to some if that’s all it was used for, rather, aggressive capital expenditure would be more conducive for the economy and the labor force.

According to Lance Roberts of Real Investment Advice, Goldman Sachs recently stated: “We expect that the tax reform legislation under the Trump administration will encourage firms to repatriate $200 billion of overseas cash next year. A significant portion of returning funds will be directed to buybacks based on the pattern of the tax holiday of 2004.”


The Deutsche Bank back in November of last year, after the Trump election, issued a 30- page opinion, titled “Trump: the huge picture for stocks,” in which it stated that they then expected the S&P 500 to easily rise to 2,250 by Trump’s inauguration, and then rise to 2,500 by 2018 “before suffering its next bear market”. Please refer to the November 2016 ZeroHedge.com article Titled: Why Deutsche Bank Thinks The S&P Is Going To 2,500 Next.

So far, this appears to be happening, the melt up in anticipation of tax reform and the repatriation of corporate cash that is being held off-shore. The result of this is that we are pushing stock valuations to historical highs, complacency is to levels typically seen towards market tops, and with bond yields expected to rise by many investors, the “TINA” ( There is no alternative) trade persists. Coupled with human behavior that as the market climb accelerates in its final stages, the final holdouts throw in the towel and jump into the market, and according to the CNN fear/Greed Index, greedy animal spirits have been pushed to extremes.

The recent frenzy has pushed the main market indexes to all-time highs. Whether or not the tax reform and the repatriation of corporate cash come to fruition remains to be seen, but the Shiller Price to Earnings Ratio is now at or above the peak levels of 1929.

So far, the year to date performance of the major market indexes is both pleasing and impressive. As of the market close on Friday, October 6th, 2017, the S&P 500, including the reinvestment of dividends, is up 15.67%, the Dow Jones Industrial Average is up 17.42%, according to Morningstar.com. The Russell 2000, which represents Small Company Stocks, is up 12.40%, and the Morningstar S&P Mid Cap Index is up 10.79%. The NASDAQ, which is heavily represented by technology stocks, is up a whopping 22.42%. One thing to note outside of equity returns is the lack of performance this year in bonds. At a glance of the Morningstar Index page of their website, most bond indexes are in the low to mid-single digits for “year to date” performance. This creates a drag on a diversified portfolio when comparing it to one of the equity indexes.

So why the run up in stocks to the point that valuations are going into the stratosphere? Well, for the reason we previously discussed which is the anticipation of the tax cut, etc. But there are other things to consider as well, which also explain why there hasn’t been any extended correction or bear market, yet.

To dig deeper, you have to consider why the presence of the “buy the dips” behavior has such a strong presence and why or how the “buy the dips” behavior has persisted for so long, meaning, every time the market dips 3%, 4%, 5%, etc., the market just seems to just turn right around and rally upward - why is that so?

Doug Kass of Seabreeze Partners Management, recently gave a good explanation as to why this is so: First, exchange traded funds, commonly referred to as ETF’s, when faced with a constant and large inflow of funds, are always rebalancing and buying, which he points out, is why all dips are purchased. The risk here is that at some point, there will be outflows and that steady dip buying and demand for stocks could disappear almost immediately. Second, he points out that the “quant funds” that are influenced by a conditioning in the algorithms to buy weakness. That buying has nothing to do with the fundamentals as the “machines” are agnostic to value, or lack thereof. One could also suggest, too, that this type of “algo” behavior has been enabled by the central banks propping up the financial system by their cash injections. Third, Kass points out that money is coming out of active managers in favor of passive investing, to the point that many high-profile active investors have closed, which means that the catalyst for fundamental-based selling no longer hold the sort of influence that they have in the past. Some other things to consider is the record amount of share buy backs that has been underway for the past 5 years, or so.

To summarize the reasons for the market run up and its resilience:

  • passive investing
  • ETFs and index funds, are now dominating markets; Machines and algorithms, as well as many individual investors, are behaving differently as they are now programmed and conditioned to buy the dips
  • 17% of the listed shares outstanding have been retired in corporate stock repurchases since the cycle low in March of 2009
  • According to Doug Kass, more than half of the listed companies on the exchanges have disappeared over the last eight years
  • Massive injections of liquidity from the world’s central banks has enabled the frenzy of riding the wave of asset purchases
  •  The animal spirits of investors has swelled and investor optimism has reached record levels which pushes investors to increase market exposure;
  • Lastly, margin debt, the debt that investors borrow against their investment accounts to buy more stocks is now at a record level.


How long this lasts and a bear market arrives, is anyone’s guess. Our wild guess, barring any significant geo-political event or sudden disruption in the financial system, is a significant market top and reversal to possibly develop the first or second quarter of 2018 – who knows, maybe sooner maybe later. But our thinking is that when it does finally arrive, it could get pretty ugly.

A bubble seems to be forming for all of the reasons we just discussed, it just doesn’t get any more extreme than this, if so, just not much more extreme. All of this is up against a backdrop of record debt levels in the world. Here in the U.S., total debt including all federal, municipal, corporate, and personal debt, now exceeds $63.4 trillion! That is an unimaginable number.                      

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Pensions are increasingly strapped and are beginning to fail, and municipalities are increasingly on the verge of bankruptcy. If we get a meaningful tax cut and a repatriation of off-shore corporate cash, perhaps the market will run up even further. But a lot of it has already been priced into the market. But a recession is bound to happen sometime down the road and perhaps in the first half or second half of 2018. Some indicators that gauge the outlook for a recession appear to be out of the danger zone but also appear to be waning. A meaningful tax reform could prolong the cycle.

Click chart to enlarge

Earnings season is ahead for Q3. We will see how corporate earnings come in, but we expect that they should be on the favorable side. However, some expect earnings overall for the third quarter to come in weaker than the previous quarters due to hurricanes, the tapering of borrowing, and weakness in some sectors such as consumer discretionary and consumer staples.

This week’s economic releases are minimal. No releases on Monday, due to the Columbus Day holiday. Tuesday has no material reports. On Wednesday, the FOMC meeting minutes will be released. And then on Thursday, there are the jobless claims along with the producer price index. And finally, on Friday is the biggest tranche of reports but none of them are really material. They include retail sales, consumer sentiment, business inventories, and the most significant one is the CPI. This may have the biggest impact on the market sentiment for the entire week.
All market sentiment remains very positive and markets continue to trade or render new highs. There is always a risk at these type of levels for a reversal point.
President Trump is suggesting that there could be more geopolitical risk to come in the markets in the next couple weeks with the North Korean situation, especially if they decide to test an intercontinental missile. This could trigger some risk off, but this is a long shot it at the moment.

Looking back on last week
Stocks began the new quarter by continuing to climb to new record highs once again. Despite the devastating shooting in Las Vegas on Sunday evening, market participants shrugged off the event as the S&P managed to post a gain of 1.19%, followed by the NASDAQ adding 1.5%. All indices were rendering new highs last week and continued to stay stable throughout the week.
Each day was a steady climb with Monday experiencing a 0.39% gain basis the S&P, Tuesday +0.22%, Wednesday +0.12%, Thursday +0.56%, and then Friday finished with a slight 0.11% loss.
During this period, we saw the VIX continue to remain under 10 with the closing on Friday at 9.65. There is virtually no real volatility and market ranges each day remain subdued but continuing to inch out gains. Most of market sentiment is being driven by expectations of tax reform. However, the GOP is already starting to show signs that it’s not going to be an easy task to achieve.
Employment numbers were released on Friday and showed a 33,000 loss of jobs last month primarily due to the hurricane’s Harvey and Irma. Meanwhile, the unemployment rate declined to 4.2% as the participation rate is rising to the highest levels we’ve seen in many years.
This did little to thwart the expectations of a rate increase in December as it is now at 93.1%, up from 77.9% last week.
Coming into this week, market sentiment and trend levels suggest that we are likely to see a continuation of the same. The minimum objective now on the upside is for a move to 2585 with the longer-term targets currently 2650/2690 representing an additional 4 to 7% on the upside.
Meanwhile, the 10-year treasury closed at 2.37% and has traded as high as 2.40%. The VPM weekly model has issued a buy signal. The average duration of the trade is 160 trading days suggesting that we will be in this upward movement for interest rates for at least six months.
There is still a potential of 4 to 6 more months of this upward pattern. The action will be critical as it unfolds over the next several weeks as the configuration suggests that there is a very short trigger on the markets. Basis the S&P 500, a close under 2484 will signal a warning sign for this sequence.

*Last week’s market recap provided by VPM Partners

Best Wishes,

Zeller Kern Investment Committee