Yesterday morning the S&P 500 hit a new intraday all-time high (1687) and then it proceeded to decline nearly 2% after Federal Reserve Chairman Bernanke suggested that the Federal Open Market Committee was looking into possibly tapering off some of the monetary stimulus in the coming months. The last two times the market hit an intraday all-time high and then proceeded to close 1% or more below that level represented the beginning of two very ugly bear markets. On March 24, 2000 the S&P 500 reached 1553 only to close the day at 1527—that was the bursting of the internet bubble and the beginning of a two year bear market that saw the S&P lose half its value. And then again on October 11, 2007 the S&P reached a new all-time intraday high of 1576 only to close the day at 1554—that was the bursting of the housing bubble and the beginning of a 17 month bear market that saw the S&P lose 57% of its value. Applying that math to yesterday’s all-time high would suggest the S&P 500 is headed to the 800 level sometime in early 2015.
We always get nervous when we hear “it’s different this time” but we really do think it’s different this time. The stock market isn’t overvalued like it was at the height of the internet bubble in 2000—today the S&P is trading at a price-to-estimated earnings multiple of 15x, in 2000 it was trading at 30x. The financial system isn’t fraught with the same hidden risks that we discovered after the housing bubble burst in 2007—banks are no longer originating mortgages for 120% of the value of the house, in fact even the best credit scores are still finding it difficult to get a jumbo mortgage for 70% of the value of the house. In 2000 the investment grade taxable bond market was yielding over 7% and in 2007 it was yielding 5.5%–in both instances the bond market offered an attractive alternative asset class to the stock market. Today the investment grade taxable bond market is yielding a meager 1.85%–it’s yielding less than the stock market and is at far greater risk should the Fed taper off its monetary stimulus than the stock market. Afterall, what is Quantitative Easing? It’s the Fed buying mortgage backed securities and US Treasury bonds to artificially reduce longer-term interest rates and consumer borrowing costs. The Fed won’t reduce that stimulus until the economy shows sustained improvement and the unemployment rate drops significantly—those are good things for the stock market. The bond market will take a direct hit when the Fed reduces its quantitative easing program, not the stock market. It is different this time.