Will the stock market “bubble” last until spring?

by Troy

Investors and traders should always be open to new ideas and different opinions. Previously I said that “medium term traders should remain defensive in Q1 2021“. Legendary investor Jeremy Grantham published his latest market outlook. I highly recommend you read it. Jeremy Grantham’s main points:

1. This is a bubble.
2. Predicting the exact top of a bubble is impossible.
3. “I know that this market can soar upwards for a few more weeks or even months – it feels like we could be anywhere between July 1999 and February 2000. My best guess as to the longest this bubble might survive is late spring or early summer, coinciding with the broad rollout of the COVID vaccine. At that moment, the most pressing issue facing the world economy will have been solved. Market participants will breathe a sigh of relief, look around, and immediately realize that the economy is still in poor shape, stimulus will shortly be cut back with the end of the COVID crisis, and valuations are absurd. “Buy the rumor, sell the news.” But remember that timing the bursting of bubbles has a long history of disappointment.”

I strongly agree with Jeremy Grantham and adjusted my market outlook:

1. Long term investors should be highly defensive right now.
2. Medium term traders should go neither long nor short. Wait. Risk:reward doesn’t favor long positions right now, while shorting into a bubble can end in disaster.
3. Short term trend followers should continue to ride the bull wave because no one knows exactly when it will end. In a “bubble”, the most profitable traders are short term trend followers who trade markets with strong animal spirits. Animal spirits generate strong uptrends and downtrends. If you are a short term trend follower, you must have tight stops.

With that being said, here are 3 interesting data points:

Decline in short interest

The stock market rally from March – present caused NYSE Short Interest to fall.

While some may see this as a bearish sign of speculative excess, that wasn’t usually the case. It was common for short interest to collapse after major periods of market & economic uncertainty:

1. After the stock market crash in August 1998
2. After the 2000-2002 bear market
3. After the 2007-2008 bear market
4. After the 2015-2016 global economic slowdown

As a result, the S&P always rallied over the next 9-12 months. This happened during the 1999 dot-com bubble, but even then the bubble continued for another half year before it popped in 2000.

Improving economy

The U.S. economy continues to improve from its lows during the lockdown. ISM Manufacturing PMI is back up to 60:

In the past, such strong PMI readings almost always led to more gains for stocks 3 months later.

Emerging markets rally

Every trend was pushed to the limit in 2020. Under this environment, emerging markets are rallying non-stop. 17% of the MSCI Emerging Markets Index is overbought:

Whether this was a bullish or bearish sign historically depended on what the market environment was. In a strong trending environment (e.g. 2003-2007 emerging markets bull), such extreme readings were simply bullish signs of strong momentum. In a non-trending environment (e.g. 2010-2020), such overbought conditions consistently led to losses over the next 3-6 months:

Thusfar we are in a strong trending environment.