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Fed, Traders Inflate Another Bubble in US Markets

Dear Speculators, 

The stock market in America has been bittersweet this year. The bulls have been rewarded and the bears have been squashed. Active trading is giving way to indexing. Interest rates have been near zero for almost 8 years and the hunt for yield makes the year look like 2006 all over again. A combination of rapid household deleveraging and low productivity growth has contributed to the sluggish economic recovery in the last seven years. To top it all off, political uncertainty looms as the Presidential elections draw near. 

However, what has kept people on their toes this year asides Donald Trump is the fear that the US market might be in a bubble and a repeat of the Global Financial Recession of 2008 is eminent. We believe in absolute terms, while measuring the value of the S&P 500 through earnings multiples, that the stock market is overvalued. But in relative terms, when you compare the earnings yields on equity versus bonds, the equity market is still fairly undervalued and has lots of room to move higher, a little greater than 20% at the moment. Our reasons are simple. Currently, the S&P 500 is selling at around 25x trailing earnings and 30 year treasury is around 2.29 percent. The earnings yield spread favours stocks and that's why equities keep moving higher. In year 2000 however, during the peak of the dot com bubble, stocks were selling at 30x earnings and bonds at 4 percent. The yield spread favoured bonds and the capital shift collapsed the stock market. Since we believe that that both equity and debt markets are possibly in bubble territory in absolute terms, the real question is what factor can burst both bubbles? 

A rapid rise in interest rate or an inflation spike could effectively be the pin that pops the US market bubble. Bonds prices will fall immediately if any of the two circumstances occur as real yield on bond investment will be trimmed. Stock prices will be corrected downwards in response to higher interest rates. This will then be followed by a massive capital shift from equity markets to debt markets because of the narrowing of the earnings yield spread between stocks and bonds. This move will be further encouraged by investor flight to safety, especially institutional investors and pension funds, forcing stock prices to fall even further. Momentum trading will spark widespread fears and instigate a sell off in the equity market and indexed exchange traded funds as investors seek to cut their losses after buying shares at lofty valuations.

Doubt us? In December 2015, the Federal Reserve (America's Central Bank) raised interest rate by 25 basis points. In January 2016, the stock market fell to one of its worst starts to the year in history! If the US markets crash, this will reduce the size of the external reserve money and wealth of nations who are heavily invested in the US debt and equity markets. The negative ripple effect of a market collapse in America will once again be felt worldwide similar to 2008 and will definitely reach the shores of Nigeria. Be very careful smart investors, we got stormy seas ahead.

Emeka Ucheaga,
Managing Partner,
Emeka Ucheaga Advisory 

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