Anytime the Dow makes a new high you can be reasonably assured of hearing the B-word bounced around in the media. Memories of the last bubble are still vivid and painful enough to trigger flashbacks of the bubble's collapse. It's only natural then that investors fear a return of irrational exuberance. Despite these fears, the evidence of a newly formed bubble is surprisingly lacking, as we'll uncover here.
Asset manager Jeremy Grantham famously defined a bubble as any asset whose price has moved at least two standard deviations above its longer-term statistical mean, or norm. This definition is too rigid, however, and can sometimes be misapplied to see bubbles where none actually exist. Markets can sometimes exceed the 2 standard deviation rule in non-bubble environments, as when the utilities sector last year experienced a 3 standard deviation event.
This definition also is overly reliant on statistics and is lacking in the psychology department. Investor psychology, after all, is a primary driving force of the pricing mechanism in all free markets. What Grantham's 2 standard deviation event rule fails to consider is that if a market experiences a record-breaking and sustained run-up, it can sometimes occur without widespread participation by small traders and investors. And without large scale participation among retail traders the psychology of a bubble is lacking, i.e. there is no bubble.
The latest rally in the major stock market averages has once again fueled talk of a mania for equities in the popular press. As discussed in previous commentaries, though, there is as yet no evidence of widespread direct participation in the equity market by small investors. Much of the movement behind the rally to new highs is courtesy of institutional activity, with the public participating only indirectly via retirement savings funds. Nowhere to be seen is the incessant preoccupation with day trading, swing trading and stock picking which were symptoms of the last two bubbles.
One explanation for this startling lack of bubble psychology despite the all-time highs in stock prices is the K-wave. Readers of this commentary should be familiar with this most basic of all long-term economic cycles, which answers roughly to the 60-year equity market cycle. The K-wave deflationary descent bottomed in 2014 based on the Kress cycle count. K-waves are often divided into four sections or "seasons" with each section being assigned a season of the year (e.g. winter, spring, summer, fall). The following graph was devised many years ago by P.Q. Wall and does an admirable job of describing the K-wave seasons.