Nasdaq is a bubble in search of a pin

I have not covered stock markets of late, because, frankly, I had nothing new to say and no trades to show using my tramline methods. Since January, stock markets have been on a tear with new all-time highs being registered almost daily in some major indexes.

Today I want to review the background to this roaring bull market. I believe we are in bubble-like conditions and the bio- and tech-heavy Nasdaq is leading the charge.

The Nasdaq looks overwhelmingly bullish

Since the late 2009 recovery phase, the market has traced out an accelerating uptrend, with the 2014/2015 action particularly steep. This is the Nasdaq 100 since 2009:

US Tech 100 spread betting chart

Before 2013, there were sizeable counter-trend dips, a sure sign of a healthy market, the type of market that I can trade with my tramline methods.

A healthy bull market is one with a major uptrend but with a large number of bears that sell into the rallies to produce healthy pull-backs (many of these pull-backs are turned at the Fibonacci levels, as I mention frequently). When the buying pressure finally takes over, the market can rally again, taking out the buy stops of the bears, and adding to the buying pressure.

The action of a healthy market is two-way; the situation today is all one-way.

Bears are scarce, and that means trouble

The chart below shows the bull/bear ratio recorded by the Investors Intelligence Advisor’s survey, a weekly survey of professional US financial advisors. The highs and lows line up with the market highs and lows; this shows that it is sentiment that drives the market.

Right now, the bull/bear ratio is at a 28-year high (the 4.2 print was last seen just before Black Monday – the famous Crash of 1987).

Dow Jones chart

Chart courtesy

Naturally, a 28-year high in the number of bullish advisors in the US stock market means a 28-year low in the number of bearish advisors. This very low bearishness has persisted on and off for about 18 months – long enough for a high degree of complacency to have set in. 

The longer the bull market runs, and the steeper the gains, the more convinced the bulls become that stocks will never turn down. Success breeds success, does it not?

Well, not necessarily; this belief is called recency bias, and I believe that it’s behind the exponential accelerating uptrend this year. 

If this is unhealthy, what does a healthy market look like?

If there are only a few bears placing short bets, who will do the buying to smooth the declines when the market finally turns down? That’s usually done by the bears as they cover (buy back) their profitable trades, but no bears means no smooth ride down.

That’s what happened prior to Black Monday 1987; few traders were short and the market plunged off the cliff with few buyers in sight.

Today, with few bears brave enough to poke their heads above ground, the bulls are simply buying and selling from themselves – just as in 1987. There’s a high risk of history repeating itself.

Something else is a little unusual in that Nasdaq chart – the number of consecutive days with gains (blue) rather than losses (red).

Note the preponderance of blue days and the paucity of red days on the rallies since last August:

US Tech 100 spread betting chart

This week, the market is making another giant leap with many more blue than red days.

This action is typical of an investment mania – AKA a bubble.

The great stock market recovery and boom since 2009 has been financed by the enormous increase in money supply engineered by the central banks. The money supply in the USA, Eurozone and Japan has accelerated even more sharply in Q4 2014, thus providing the fuel for the Nasdaq fire this quarter (see top chart).

Not only that, but banks and hedge funds can leverage their central bank loans by many multiples, thus providing even more buying power.

So how will this end?  No doubt about it: it’ll end badly (for the bulls).

JM Keynes famously said: “Markets can remain irrational longer than you can remain solvent”. But the time to be short will arrive.