Probability of a Crash Increasing Exponentially

from Dr. John Hussman's market commentary earlier this week:

Here are two links and brief explanations of this acceleration phenomena that is depicted in this graph:
This first link is to a paper on the website of the National Bureau of Economic Research. The NBER is the group that OFFICIALLY declares when a recession begins and ends. In their paper, they explain the phenomenon that as a bubble matures, it ACCELERATES higher, and why that contributes to the ensuing crash. Here is a quote that summarizes the paper:

“The probability that the bubble ends may well be a function of how long the bubble has lasted, or of how far the price is from market fundamentals. If the probability of a crash increases for example, the price, in the event the crash does not take place, will have to increase faster, not only to compensate for the increased probability of a fall, but also to compensate for the large risk involved in holding the asset.”

And here is the paper (pdf format). The paper is very academic and arcane, with lots of complex math, so unless you are a math whiz, don't expect to be able to understand all of it:

http://www.nber.org/papers/w09 45.pdf

 This second link is to Dr. John Hussman's market commentary from earlier this week:

http://www.hussmanfunds.com/wm c/wmc131230.htm

Here is a quick summary of this rising risk of a crash, which I've taken from Hussman's most recent market commentary:

“As the price variation speeds up, the no-arbitrage condition, together with rational expectations, then implies that there must be an underlying risk, not yet revealed in the price dynamics, which justifies this apparent free ride and free lunch. The fundamental logic here is that the no-arbitrage condition, together with rational expectations, automatically implies a dramatic increase of a risk looming ahead each time the price appreciates significantly, such as in a speculative frenzy or in a bubble. This is the conclusion that rational traders will reach. This phenomenon can be summarized by the following proverb applied to an accelerating bullish market: ‘It’s too good to be true.’” Didier Sornette, Why Stock Markets Crash, 2003

“Our positions are always built on observable evidence rather than scenarios. We already have sufficient evidence to be fully defensive. Only later will we read in the headlines exactly why this defensive position was warranted.” John Hussman, PhD 12/23/2013 

 "My guess is that the present speculative advance may have a few percent to run – I’ll be particularly concerned if the market does so in a rapid, uncorrected manner in the next couple of weeks, which could suggest crash probabilities approaching 100% based on the sort of analysis above." John Hussman, PhD, 12/23/2013

The Statistical Probability of a Stock Market Crash

This from Dr. John Hussman:

The probability of a stock market crash is increasing exponentially in the past 30 days.

Dow Stocks Up Another 70 Points

Stocks Euphoric!

10-Year Hits 3%!

Higher debt service costs are likely as long as the Fed continues to taper.

Note to a Friend About Current State of Financial Markets

Following is the text of an email I sent earlier today:

I hope you and your family had a great Christmas!

I read several articles on the Kiyosaki website. I am a fan of Robert Kiyosaki, and I've read 2-3 of his books (just not recently)! I like this quote in particular from his website, written by Richard Duncan:
"The press has attributed the Fed’s decision to taper to an improvement in the outlook for the economy. I don’t believe that is the correct explanation. The recovery is still too weak and uncertain to justify tapering on those grounds. In my opinion, the real reason is to prevent excess liquidity from creating a new, destabilizing asset price bubble in stocks and property."

But stocks continue the ramp-up into record territory. The futures are higher today (Dec 26), and are set to hit the 50th all-time record high this year -- again, if stocks remain at these levels by the end of the day today. But the volume is razor thin, even for holiday trading (thin trading is typical for holidays, but this is exceptional even for a holiday)!

I also perused Richard Duncan's economics website, and saved it. He's very sharp, in my opinion. I then did some research on Mr. Duncan. He has been interviewed numerous times in the media. He has also written some best-selling books. I then remembered having seen him in a very lengthy interview several months ago, which I found on Youtube and watched again. He had just released his new book titled The New Depression in early 2012. He said that due to excessive debt over the past several decades to fuel domestic consumption, we have created bubble upon bubble, and that bubble will eventually collapse in a depression that he says will last for "generations" (HIS word, not mine).

I also read some of the reviews of Mr. Duncan's book on Amazon.com. There were two reviews that were extensive and were several pages long. You can read them there if you want, but be forewarned that they were quite lengthy! They were some of the most expansive reviews I've ever read on Amazon. They must have taken hours to write. After reading them, I decided that I didn't need to buy Duncan's book because I knew all the salient points in them.

Two of the lengthier reviews critiqued Duncan's proposed "solution" to our debt crisis. In the book, he proposes that the US government borrow even MORE, go into even deeper debt, and "invest" in advanced technologies in alternative energies, nanotechnology, etc. He said that he believes that if the government does this, it can ensure that the US "empire" will endure another century. So his solution is even MORE government debt and government programs in a bet that we can perpetuate our technology edge for the next century. The lengthy reviews were skeptical, but fair.

Over the past year, I've read at least five books that are dedicated, either in whole or in part, to describing asset bubbles and their characteristics. One of them was so arcane that I had to borrow it from the BYU library, where it had only been checked out 3 previous times in 10 years. I've taken notes of some of the characteristics of what constitutes bubbles. What we are seeing now in stocks manifests every single characteristic of a bubble that I've read. Attached is a chart that Dr. John Hussman published this week (the one with the white background) . It shows the current stock market, and is literally a textbook example of what an asset bubble looks like. In fact, in the advanced stages of what he called a log-periodic Sornette-style bubble (Swiss academic Didier Sornette was the author of the book I borrowed from the BYU library, which I heard about from Hussman), the asset bubble goes parabolic as investors not only increase their bets without abandon, but they even go into DEBT to do it. Margin debt is now at record levels, which Hussman also mentioned this week in his online commentary on his website. Margin debt not only amplifies the gains on the way up, but the losses to investors also amplify the speed of decline on the way down. Crashes occur much faster than rallies for this reason. Hussman reminds us that we have already seen TWO stock market crashes in the past ten years (2003 and 2007-2008). But he also says that stocks may increase an additional 5% before they crash again. That would put the S&P 500 at about 1920. It's trading on my futures charts at 1832 as I type this. We could reach 1920 over the next 90 days.

In Hussman's chart, note that as the asset bubble matures, the asset goes increasingly parabolic -- straight up! There are no more pull-backs or retracements whatsoever. Stocks, for example, have barely looked back since mid-2012, since the fed began QE-Infinity! On his chart, the red line is what a bubble historically looks like, and the blue line is the current S&P 500. They are virtually identical!

On my other chart that I've attached (black background), which is a screen capture from my own (monthly) charts on my PC from one week ago (and stocks have gone even higher since), you'll also see that stocks are no longer even pulling back to the exponential moving average (light blue line). They are even trading much of the time above the purple line, which is the upper Bollinger Band, which represents two standard deviations (a chance to use your statistics from biz school) outside the norm. We're now close to THREE standard deviations!

I don't try to forecast the future. I have a saying I made up: "Predicting the future is for prophets, not profits". I don't know what the future holds. I trade based upon what the charts and the market tell me, NOT what prognosticators say. Prognosticators have a historically poor track record! BUT -- I know a bubble when I see one. All it will take is another "Lehman Bros moment" that triggers a sudden collapse in confidence, and the next crash will ensue (John Mauldin wrote about this extensively in his book Endgame). I have no idea what that trigger event will be. But I am certain it will come. And the more euphoric Wall St becomes, and the more they ignore the red flags, the more likely that event will occur with immensely cataclysmic consequences.

One small note: public sentiment (measured by "consumer confidence" indicators), tends to mirror the stock market -- NOT vice versa! (see 2 Ne 28:21)

Interestingly, over the past few months, I've read information from some of Pres. Obama's advisers that indicates that they INTEND to bring "fiscal collapse" (their term, not mine) to the US government. Remember "never let a crisis go to waste"? If you don't have a crisis, you CREATE one! That reminds me of what the secret combinations did in 3 Ne 7! I'll share with you those details next time we have a chance to get together to chat.

The market just opened, and I need to go. There is a new book out by John Mauldin, called Code Red. I asked for the local library to get it so I can read it. They said it will arrive after Jan 1st (new budget). Mauldin, after being quite optimistic over the past few years, has suddenly turned somewhat pessimistic over the course of 2013. I want to read his book to learn why. His last book was about what he and others have termed "the debt supercycle" which is coming to an end soon. Duncan also expressed his worries about the same phenom. I use the term The Mother of All Bubbles to refer to US government debt. When that bubble pops, we will have a depression that Duncan says will likely last for DECADES, even generations. That's his opinion! Wow!

One last thing and then I MUST go:
re: deflation
There hasn't been broad-based deflation since the Fed was created. The dollar has depreciated 98% since then. (By the way, the Fed's 100th anniversary was Dec 23d -- the same day as Joseph Smith's birthday. One was a great day in history, and the other was a day of infamy!) I'm convinced that inflation is a better bet than deflation. We HAVE seen some deflation, most notably in housing, but the deflation was from BUBBLE levels. We all know that food and energy inflation are MORE likely, not less. Notwithstanding the gas price deflation you mentioned, the price of gas is still almost DOUBLE the price of gasoline when Obama took office. For this time of year (there are seasonal aspects to crude/gas prices), gas prices are unusually high.

Well, time to go to work. Let's keep up the dialogue. I appreciate having someone with your knowledge and background to palaver with.

Keep up the great work! I appreciate your example and ethic!

God bless!

Steve

Session Ends Higher, Another New Record

Dow finished up another 63 points today!

And Stocks Hit New Record Highs

...for the 49th time this year!

Mixed Messages In Today's Headlines

Meanwhile, stocks are hitting fresh all-time record highs.

Holiday shopping is weak this year, but that doesn't appear to have dampened Wall St.'s euphoric love of stocks.

And mortgage loan applications just sunk to a 13-year low, with refinance loan applications hitting a 5-year nadir.

But on the other hand, durable goods orders showed a healthy increase:

But there is a dark side to this news! The government used that old tool that we have all come to love -- those "seasonal adjustments" -- to inflate the durable goods figures! Furthermore, Durables Goods ex-transports was DOWN by -0.5% instead of rising by 1.2%.

Consumer Sentiment Is Up, Even As Consumer SAVINGS Slides

Bubble Acceleration Noted

This is the monthly chart of the current S&P 500 stock index. This is literally a textbook case of what a bubble looks like. There are many characteristics of a bubble, and I literally can't think of a single one that this current market circumstance does NOT manifest. 

Note in this chart the light blue line, which represents the 8-period EXPONENTIAL moving average. Take note also that as stocks accelerate higher and higher, faster and faster, they are leaving even this "exponential" acceleration far behind. Despite that stocks are already valued at excessive levels from a historical perspective, investors are willing to pay even MORE for them. Is that rational behavior?
Last week, Dr. John Hussman did analysis on his website that indicated that corporate earnings are now beginning to stagnate and are likely over coming quarters to collapse back to more historically normal levels that would be about 40% below today's levels. But even still, speculators are paying even higher prices for stocks, driving valuations beyond even these historical levels. Stocks are, after all, the price an investor pays for a stream of earnings extending into the future. If an investor pays too much for them, then their YIELD on those earnings will be poor. Dr. Hussman has calculated that at earnings levels of the past few months, an investor's yield for the next ten years, based upon historical patterns, will likely be near ZERO. Here is what Dr. Hussman said today about the current bubble market:
"Regardless of last week’s slight tapering of the Federal Reserve’s policy of quantitative easing, speculators appear intent on completing the same bubble pattern that has attended a score of previous financial bubbles in equity markets, commodities, and other assets throughout history and across the globe." (emphasis mine)
Something else that is noteworthy in the above chart:
In the past, even in this overbullish market, stocks have traded between the light blue line (the exponential moving average), and the upper Bollinger Band, which represents, from a statistical perspective, TWO standard deviations outside the norm. In the past few months, stocks haven't even dropped back to the light blue line. Stocks barely made it half way back to that level. This bubble is accelerating even faster to stratospheric levels, only guaranteeing that when reality finally can no longer be denied, this house of cards will also follow historical patterns of what a popping bubble looks like.
As further evidence of how overbought this market is, note also that the last time stocks even closed below the blue line was in mid-2012 -- a year and a half ago! Stocks have barely even looked back since then! And this, despite already stratospheric price levels!

OVERNIGHT
This chart following shows the acceleration of stocks during the overnight sessions in Asia and Europe.

This shows the Dow futures over the past few hours. Stocks are already 57 points higher than last Friday's close. This stock market bubble is advancing at an accelerating pace. 

Stocks Continue Record-Setting Climb

Friday's relatively strong GDP reading sent stocks to new record highs, and Sunday evening, stocks set still another record.