■ A new model suggests that from early 2017 through much of 2018, the U.S. stock market was a bubble.
■ Driven by negative changes in sentiment, the bubble started to deflate in the fourth quarter of 2018, in spite of strong fundamentals.
■ Our advice, consistent with our portfolio positions established in Q1 2018 – as usual, we were early – is to own as little U.S. equity as your career risk allows.
In the fourth quarter of 2018, the S&P 500 fell almost 14%. This large price drop occurred in spite of a strong fundamental backdrop. Earnings per share (EPS) for 2018, much of it already locked in, is expected to be about $140, a 28% increase over 2017. And expectations for 2019 are for EPS of about $156, a 12% annual increase. With fundamentals so good, what explains the recent price action?
A new model – the Bubble Model1 – explains this dichotomy between price action and fundamentals by suggesting that a bubble in the U.S. stock market started inflating in early 2017, and continued to inflate through the third quarter of 2018.2 In the fourth quarter, however, indications were that the bubble had started to deflate. And when bubbles deflate, they generally do so with a volatility bang.
In this new model, bubbles are prone to form when times are good and expected to get even better. Good times today and even better times ahead are reflected in high valuations and solid fundamentals that continue to improve. Improving fundamentals lead to positive changes in sentiment, and these positive changes in sentiment fuel the bubble. However, sentiment cannot increase forever. When change in sentiment – not level – inevitably turns negative as hopes of even better times ahead are dashed, there is nothing left to fuel the bubble.
In the context of market action over the past quarter, expectations of decelerating earnings growth – albeit still positive – reflect a negative change in sentiment. Furthermore, between August and December of 2018, estimated EPS for 2019 fell from $163.51 to $156.28, a decline of more than 4%. These earnings changes could reflect negative changes in sentiment. But other concerns, such as tightening by the Federal Reserve and trade tensions with China, can also cause negative changes in sentiment. And it is negative changes in sentiment – defined broadly – that can catalyze the pop.
While there are indications that the bubble started to deflate in the fourth quarter of 2018, and the magnitude of both price action and the change in the quantitative measure of euphoria that defines the Bubble Model suggest that the odds are now tilted in favor of the view that this is the beginning of the end of the bubble, we would be well-advised to remember Yogi Berra’s counsel that “It ain’t over till it’s over.” Past bubbles do exhibit “head fakes” in which bubble deflation is interrupted by a secondary growth event. For example, in the third quarter of 1998, the time of the LTCM crisis, the Bubble Model suggested the bursting of the bubble that had started inflating in early 1997.3 However, the 1998 reading was a head fake, and the bubble continued to grow for another 18 months before finally popping in early 2000.