What’s Worse Than a Bubble
to Bear Market?

What’s worse than a bubble to bear market? A system that isn’t allowed to correct itself.The S&P 500 Index did a good job of breaking out of its correction trading range (1,220 to 1,100), but it is now getting close to returning to this range due to the continued lack of certainty in Europe. What’s required over there is decisive action, both politically and monetarily.

The U.S.stock market should be trading higher than it is. Corporate earnings in the third quarter were really good and they have been all year. This past earnings season was usurped by the sovereign debt crisis in Europe and declining investor sentiment is evidenced by declining trading volume.

Corporate earnings are solid. This doesn’t mean that business is booming or anything like that and it doesn’t mean that all industries are experiencing the same amount of business activity. But, we’ve seen corporate earnings come in impressively stronger than revenues and, from what I’ve read, visibility going into 2012 is decent. (See The Stock Market’s New Best Friend—Buffett Will Be Pleased.) With investment risk high in virtually all financial markets (the reason why Treasury yields are so low), the U.S. stock market is getting the brunt of the world’s declining expectations.

If you pull up a really long-term stock chart on the S&P 500 Index, you can see the runaway price action of the stock market, especially in the late 1990s. It wasn’t as if corporate earnings were accelerating dramatically during this period; it was more so the stock market’s valuation of those corporate earnings that increased the most. This was best illustrated with Internet stocks, the shares of which soared without any corporate earnings at all. Ever since the bubble burst in 2000, the stock market’s been in correction mode, trying to find itself a new equilibrium between reasonable corporate earnings and overly high valuations.

The S&P 500 Index continues to have an ominous looking trading pattern, with the stock market clearly producing a right shoulder formation. Unfortunately, the index’s supported low over the last decade has twice been around the 800 level. For me, just looking at the stock market’s chart for this period doesn’t inspire confidence.

If we go by corporate earnings, then I think it’s fair to say that the stock market today is very reasonably priced. As we’re not in any particular stock market bubble, the fair valuation on corporate earnings is arguably helping to keep the trading action as good as it is.

I have to admit that I have this great fear for the U.S.stock market. If you look at Japan’s Nikkei Index, you see the amazing wealth creation that occurred in the 1980s and the spectacular crash of the stock market ever since. The Japanese stock market has been in a bear market for the last 21 years. Then you have the Chinese stock market, where the China Shanghai Index more than quintupled from 2006 to 2008, only to have given up almost all of this gain. Corporate earnings growth was fairly steady during this period, but stock market valuations were not.

I have faith that the U.S.equities won’t experience that same kind of trading action that occurred in Japan.U.S.multinationals are extremely good at growing corporate earnings, even during sustained periods of global economic weakness.Europe, however, must allow its debt crisis to correct itself, because the policy intervention to date is only sugarcoating the problem. Lack of action on the issue continues to hold the U.S.stock market hostage. So what’s worse than a bubble to bear market? A system that isn’t allowed to correct itself.