At this stage, the burden of proof must surely lie with those bulls who claim that current market prices are entirely justified by fundamentals. Nearly two weeks ago, I highlighted 5 Signs Irrational Exuberance Is Back. I certainly didn't expect the process to reverse on publication of the article, so I remained vigilant for other signals that sentiment, not rationality, is driving this market. It didn't take long for me to collect five more (bulls -- please leave intelligent counterarguments in the "Comments" section below the article):
1. Stocks are still overpriced. In his latest note to clients, Andrew Smithers -- who literally wrote the book on market valuation -- reckons the U.S. market is now approximately 40% overvalued. That number is based on a comparison between the S&P 500's current cyclically adjusted P/E multiple (the CAPE, which uses average inflation-adjusted earnings in order to smooth out the fluctuations of the business cycle) and its long-term historical average.
The CAPE isn't a lone data point, either. Smithers writes that Tobin's q ratio -- which compares the market value of equities to their net worth at replacement cost -- points to a similar degree of overvaluation in U.S. stocks.
2. The IPO market is back. The third quarter was the strongest for U.S. IPOs since the first quarter of 2008, with 20 offerings for a cumulative value of $5.8 billion. That trend looks set to continue with 34 registrants seeking to raise $10.9 billion at the end of last quarter against 28 aiming to raise $7.6 billion at the end of the second quarter. Notably, technology is the best represented sector -- with six registrants newly filed in August and September.
Successful IPOs depend on positive sentiment. While we're still far from the "glory days" of 2007 (thankfully), this resurgence in the IPO market suggests there is a strong, increasing appetite for risk assets.
3. Asset managers are floating shares. Among the new IPOs, some are more telling than others. English fund manager Gartmore could register plans to float shares this week. Asset management firms earn a percentage of their assets under management (AUM). Rising markets swell existing AUM and encourage new asset inflows; thus, investors reward asset managers with rich valuations when markets are ebullient, not depressed. Gartmore's owners, a shrewd LBO group named Hellman & Friedman, know this; the timing of the IPO -- which they expect to complete by year-end -- is anything but casual.
A legendary LBO group, KKR, went public within the last month by merging with an affiliate listed on Euronext Amsterdam (part of NYSE Euronext
4. The towering inferno. Less than two weeks ago, Henderson Land, a large Hong Kong property developer, announced that it had sold a high-rise apartment for 439 million Hong Kong dollars (US$56.6 million). At a cost per square foot of useable area equivalent to US$11,350, Henderson affirms it is a record sale for Hong Kong and believes it trumps all transactions anywhere in the world.
This is simply the most blatant example of a Chinese property bubble fueled by cheap money; Hong Kong home prices have risen by 28% so far this year.
5. John Meriwether is launching a hedge fund ... again. Surely you remember Mr. Meriwether: In 1998, he introduced us to the notion of "too interconnected to fail" when the Fed orchestrated a bank-led rescue of his massively leveraged hedge fund, Long-Term Capital Management. (The rescuers included Goldman Sachs
Undeterred by having threatened global financial stability, Meriwether created a new fund soon thereafter, boasting similar strategies with lower leverage. Unfortunately, 10:1 leverage was still too high for last year's jarring volatility, and Meriwether shuttered the fund after inflicting a 44% loss on his investors.
"Third time's a charm," must be Meriwether's new pitch. He's back soliciting assets from well-heeled investors for a fund to launch in 2010 ... following the same strategy as the first two. I propose a new contrarian indicator: When there is enough risk appetite for John Meriwether to start fundraising for a new hedge fund, investors must consider rebalancing their portfolios toward lower-risk assets.
Bubble or not, my recommendations
It may be premature to say that we are already in another full-fledged bubble, but it should be clear that the combination of government-sponsored liquidity and low fixed interest rates is distorting the pricing of risk and stoking bubbles in many areas of the capital markets. U.S. investors should think twice before chasing stock returns; if you must be fully allocated to U.S. equities, my recommendation is to focus on the highest-quality segment of U.S. corporations. Alternatively, you could trade some of your U.S. exposure for international stock exposure (although I'd be wary of red-hot China -- they've got a highly effective bubble machine of their own).