It is always hard to tell when a market has gone from being just a little maddening to becoming a full-blown bubble, but we are starting to see some telltale signs.
One of those signs is the classic market bifurcation. Over the last year, everyone has done well on an absolute basis but some have done much better than others. Over the twelve month period ending March 31, 2011, the Russell 1000 was up 16.69 percent, but the Russell 2000 was up 25.79 percent. At quarter-end the Russell 1000 had a P/E Ratio of 17.2, compared to the Russell 2000 P/E Ratio of 29.9. The out-performance of small-cap stocks cannot continue with that big of a P/E dispersion, or so one would think.
Commodities are up even more, many over 100 percent. Last quarter the energy sector in the S&P was up 16.8 percent. Gold, which was ridiculously priced at $1,000 per ounce, is now $1,500 per ounce. Silver is through the roof as are less sexy commodities like cotton. These are all supposedly hedges on inflation, yet the only inflation the eye can see is the commodities themselves. Wages are not growing. GDP growth is low, so where is the actual inflation? There is a great deal of talk about inflation because of food and fuel costs, but economically inflation means the cost of everything rises. Inflation occurs when prices rise and people pay those higher prices through a combination of higher wages and increased debt. In true inflation you must have more money to spend, and we don’t have that today. There is next to no wage pressure and consumers are not borrowing money; if anything, it is the opposite. Today what we see is prices rising in specific areas and people adjusting by spending less elsewhere.
The overall market return is not surprising as much as what is actually driving the market: momentum. Things that have been going up keep going up. When momentum gets carried away and assets that seem overvalued continue to rise while simultaneously assets that seem reasonably valued are ignored, it starts to look and smell like a bubble. The last thing that happens in a bubble is that the really smart money managers, the ones who care about things like fundamental valuations, start to underperform. This is happening. These are signs.
There are also signs that the bubble may be bursting. Commodities have come under pressure. Most notably silver is down nearly 30 percent, but it is hardly alone. Yesterday a host of poor manufacturing reports from around the globe contributed to the commodity downfall. Small cap stocks are already in the red over the last four weeks and large caps may well join them.
My hope is this is just the beginning of a market correction followed by a rotation into more sound areas of the market. Yet my fear is…here we go again!
Chuck Osborne, CFA
Managing Director
