Events of the past week, the parabolic rise in the stock price of GameStop (ticker: GME), the poster child for short squeeze and several other heavily shorted stocks such as Bed Bath and Beyond (ticker: BBBY), Blackberry (ticker: BB); AMC Entertainment holdings (ticker: AMC) and American Airlines (ticker: AAL), may be an indicator of the fact that we are at the peak of bubble cycle and on last leg of the game of musical chairs.  When the music stops, there will be some one sitting on the chair still and the outcome may not be pretty for those!

The activities of the past week and the rampant retail speculation intermixed with ideological views such as “sticking it up to the hedge funds” to me is a clear indicator of things to come as is very well highlighted in the following market cycle chart

Greed, delusion and new paradigm are all appropriate terms that come to mind when thinking about whats just transpired with GME stock. Just how well the chart above describes market cycles, can be seen by the following two examples, where we overlay the dot-com bubble cycle and the more bitcoin bubble phase (from late 2017)

Here’s another beautiful chart from Advisor Perspective, looking at the regression trend for long-term market performance

Markets are currently at 154 % above the trend line, the highest its ever been. The last time we saw >100 % overshoot was during the dot-com bubble era of late 1990’s.

Yet another popular indicator, the so-called Buffet indicator, that measures the market cap index to the gross domestic product (GDP) is shown below

I have overlayed the value of Buffet indicator during the past two notable bubble events, namely, the dot-com and the housing bubble. As of Q4 2020, the ratio stands at an unprecedented level of 2.168, and as an omage to the events of past week, I am logging this as the GME bubble. Only time will tell whether the events of past week represent the instance when the bubble eventually burst!

Another popular macro market indicator is the cyclically adjusted PE ratio (or the Shiller CAPE ratio), which is shown below

As of this writing the CAPE ratio stands at 33.82, well below the dot-com peak value of 44.19 reached in Dec 1999. The meteoric rise in CAPE leading to the 1929 crash and the dot-com bubble is clearly visible from the chart. But CAPE completely missed the housing bubble as well. Viewed through the lens of CAPE then it is not very clear whether the current value of 33.82, which is the second highest thus far and the trend producing this number offers any indication of market peak!

However as Shiller notes, when looking from the perspective of treasury yield, the extremely low interest rates may justify todays stock prices. The Shiller excess CAPE yield (ECY), defined as the inverse of CAPE (1/33 approx 3 %), minus the 10-year interest rate, adjusted for 2 % inflation over the past 10 years, at around -1 %, is about 4 %. This is the highest since ~2014 as can be seen from the chart below

Quite interestingly as Shiller and team report, the ECY is even more attractive in global markets, around 10 % in UK and 6 % for Europe and Japan.

Another way of looking at the yield differential is the difference between the expected inflation adjusted 10-year Treasury yield and the S&P 500 forward earnings yield, see below

As of Nov 2020, the spread was around 5.6 %, which if anything suggest stocks are relatively cheap. Note that at the height of dot-com bubble, the yield was zero!

So where does this leave us… interest rate independent metrics suggest, stocks are extremely expensive, however, taking into account the current interest rate environment, the market does not seem that expensive. To get further insight into segments of markets that are optically expensive vs not, lets look at the following chart

Cyclical sectors are Financials, Industrials, Energy and Materials. Growth, stability and defense sectors are Tech, Communications, Health Care, the Consumer sectors, Utilities and Real Estate. In past 100 years, cyclical sectors have never been this depressed in terms of their weighted contribution to the S&P 500 index.

Unsurprisingly so, the pandemic wiped out revenue of many cyclical firms directly. Airlines ground to halt, energy companies has a huge write-off with oil prices plunging and materials business was impacted by stand still in construction activities. On the other hand, growth sector thrived, especially in the current low interest environment (and because of the its DCF stupid!! analysis). Future growth and earnings matter more in current environment as money is cheap but as the tide turns and interest rates bounce back, and as the economy recovers from pandemic we should see some sort of reversion to mean with cyclicals finally starting to catch up to the growth stocks.

And there in lies the solution to the contradictory indicators… Markets are expensive, most certainly in certain sectors but are extremely cheap in others.

Video/Book/Article/Audio for the Week

• Podcast: Cathie Wood of AQR capital on the We Study Billionaires podcast. For those who don’t know, Cathie Wood predicted Tesla to reach $4000 pre-split 3-years earlier (at a time when most talk around Tesla was the firm was going bankrupt). Her firm has been in the spotlight recently given the stunning 2020 for the AQR funds. While AQR focus on tech disruptors and fast growing companies (with no current positive cash flow) does not fit my style of investing, its worth hearing her out and her thesis of 5 tech driven disruptor sectors of the future
• Podcast: Yet another excellent podcast interview by Bill Brewster with Jen Ross, professional short-seller. Fascinating to hear short view on Tesla and to contrast with the bullish view by Cathie Wood from this week.
• Podcast: One more for the week, Stansberry Investor Hour interview with Andrew Beer of Dynamic Beta Investing. Andrew presents an interesting opportunity related to mimicking hedge fund gains with affordable fee structure within an ETF vehicle. This interview led me to start digging into the managed futures world!
• Podcast: A final one for the week, this one again on Stansberry Investor Hour, where Dan Ferris speaks with Peter Brandt, a trading legend and “market wizard”.