Salient to Investors:

James A. Kostohryz writes:

Stock valuations are currently within or even slightly above a broad range that could be considered “normal” and not at bubble levels, but unprecedented levels of excess liquidity, declining liquidity preference, and a number of fundamental, technical and psychological indicators strongly indicate a bubble is forming. Probabilities favor further sharp rises in stock prices within in the next 12 months.

Rising asset prices driven by excess liquidity and declining liquidity preferences is symptomatic of long-term pathologies that are developing beneath the surface in economic and financial conditions.

The S&P 500 at 1690 implies a forward 12-month P/E of 15.1 versus the historical average of 12.9 since 1976. The current P/E on a trailing 12-Month EPS is at 18.47 versus its long-term historical average since 1871 of 15.5.

However, the forward P/E average is downward biased due to the start date as well as by inflation-induced earnings distortions that artificially inflated GAAP earnings during the mid 70s and early 80s. Historical P/E data prior to 1960 was in a radically different world than today. Other valuation methods are superior to simple historical P/E comparisons.

The Fed will be unable to prevent bubbles from forming given its dual mandate to promote price stability and full employment. The Fed is keenly aware of the risk of asset bubble formation and this was the reason for its recent warning about tapering. Despite any jawboning, the Fed will always choose reducing high unemployment over asset bubble prevention as long as consumer price inflation is contained.

Tapering does not involve any withdrawal of excess liquidity from the system, so tapering is functionally an enabler of asset bubble formation.

Bubbles are not merely a matter of extreme overvaluation because other fundamental, technical and psychological elements come into play.

In the past 8-9 months, expectations of GDP and earnings growth have been steadily declining while real interest rates have been rising and stock valuations have been rising rapidly above their historical mean levels – a sign of potential of a bubble formation.

The slope of the extraordinary rise in the stock market since last fall, the rise’s persistence, the extraordinary decline in volatility and lack of correction or consolidation, all indicate potential bubble formation.

The caution of many retail and institutional investors in their allocation to equities relative to historical norms is in the process of being thrown to the wind. Many investors are investing in equities because they feel that they have nowhere else to go, an indicator of potential bubble formation.

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