Bubbles: What Happens When Absolute Insanity Prevails?

An old friend walked into my office the other day and told me I was dead wrong about the stock market being overvalued and overbought. “Michael, it looks like key stock indices can go even higher next year.” His reasoning: the Fed won’t stop printing and that means “the market can only go up.”

This is exactly where the trouble begins.

You see, I have read a lot about bubbles…and not just the ones in key stock indices. All bubbles have one thing in common: when bubbles get bigger, optimism goes mainstream.

Looking back, you will see this yourself. During Tulip Mania, the general consensus was that tulip prices would only go higher—they did, but then they came crashing down. The housing market bubble of 2004–2006 is another prime example of this. Back then, I remember everyone talked about how home prices would only go up. People took risks beyond imagination. They talked about getting a third mortgage to buy another investment property and many investors I talked to were juggling several properties. Home prices then collapsed.

I believe the stock market of today is clearly displaying signs of a classic bubble.

Sadly, investors continue to buy into it. According to the Investment Company Institute, between the weeks ended November 6, 2013 and December 4, 2013, long-term stock mutual funds saw an inflow of $24.8 billion. (Source: Investment Company Institute, December 11, 2013.)

Meanwhile, the number of stock advisors bullish on key stock indices continues to rise. Insiders are selling more stock than they are buying. The VIX (Volatility Index) is near a record four-year low. Margin to buy stock is at an all-time high. I can’t find any time-proven indicators that say this market is not overpriced and overbought!

Dear reader, I can’t stress this enough: The fundamentals that drive the key stock indices higher are fragile. There’s a massive disparity between the performance of the stock market and factors like corporate earnings growth and general economic conditions.

As it stands, irrationality prevails for key stock indices. Bad news is taken as good news, and the good news is taken as better news.

Unlike my old friend, I remain skeptical about the performance of key stock indices. I know bubbles can stretch longer than most people envision, and it is very difficult to predict when they will burst—but this stock market bubble will burst big.