Over the past 20 years we have experienced stock and economic “bubbles” of various forms.  Identifying these bubbles can guide investors on to how to invest and how to gage risk in the investments that may be in their portfolios.  Bubbles are created by some form of stimulus.  The first bubble in 1992-2000 was created by the internet boom, as well as the thinking at that time that stock values would increase to incomprehensible levels. The second bubble was created in the late 90s and topped in 2005/2006; this was the real estate bubble.  Money was cheap and easy to get from banks.  This created valuation double digit gains in housing and commercial property during this time.  When it broke to the downside, it took everything with it.  The third bubble, our current bubble, is a monetary bubble.  The various agencies (Federal Reserve and European Central Bank) bail out assets, lower rates to zero, and provide liquidity to the market.

Let’s review these three bubbles:

The “Tech Bubble” occurred in the 90s as “old school” investor thinking was challenged, and Wall Street had us all believing in a new normal.  For example, the overall stock market PE of the US since infancy typically fell in the 8-15 range; in the late 90s, it reached above 20, 30 and some stocks over 100.  Old School thinking was thrown to the curb.  Wall Street convinced us that the market was going higher and higher.  We have a book in our office that was written during that time titled Dow 40,000.  This bubble was also a Euphoria Bubble.  Money was thrown at anything with hopes of making money, and it worked for a while.  Even public stocks that were not making any money went up in price.  But, as we have all come to painfully learn, when bubbles break, they break fast and furious.  In the months of Feb/March of 2000, many mutual funds lost more than 20% of their value.  Cisco, a favorite of the 1990s, traded in the high 60s, and had a few stock splits.  Today, even though it is a well- managed and diverse company, the stock is trading at about $19.

Next, after 3 poor stock market years (2000-2002), the market regained some footing and put together 5 years of gains.  The average “up” market in the history of the stock market lasted 24-34 months.  This one lasted 5 years, so it was a good move.  At the end of 2007 investor complacency set in, and lessons from 2000 were eroding.  What was happening, however, was the “crack” that many people underestimated.  The housing bubble started to crack.

In late 2008 the 3rd bubble, which we label as the Federal Reserve/ECB bubble, was in its infancy.  The level of debt that many countries are currently under is unsustainable.  It would be comparable to your mortgage payment being 100% or more of your monthly income.  The Federal Reserve started in late 2008 attempting to stimulate the economy by lowering interest rates.  The Fed also implemented what is known as Quantitative Easing.  QE1 and QE2 were announced during the stock market crashes respectively in 2008 and in 2010 (on the 20% drop).  Both were successful in stopping further stock market drops, and, in turn, caused the markets to rally for the 6 to 8 months which followed each announcement.

Two weeks ago, even after the market climbed to the 13,500-14,000 target that we forecasted in Feb 2012, the Federal Reserve announced QE3.  QE3 is a big number; $40 Billion in mortgage bond purchases over the next 12 months.  This will keep mortgage rates low over the next year.  It is odd that this was announced now as the stock market is perceived as improving.  Smart investors know that the Federal Reserve would not announce this if they saw a healthy economy, one that could stand on its own.  This announcement signifies to us that the economy is still on fragile ground. With this announcement alongside the fact that we see the development of the 3rd bubble of our time, the stock market should continue to be stable for the next 6 to 12 months….and higher.  The stimulus should continue to keep the bond and stock markets stable as we should approach 14,000 by the end of the year.  It is also logical to increase our targeted forecast to 14,500-15,000 by the end of 2013…possibly higher if the Federal Reserve continues to print money.  Inflation should continue to rise.

We continue to watch for a “black swan” to change this climate; at this time, however, the market continues to climb the wall of worry, and we see no change of this in the near term.  If our forecast changes, we will inform our clients immediately.  We are monitoring this market very closely, because bubbles do break eventually.  If our forecast of the market moves higher, we will communicate that as well, but let’s see if 14,000 is reached by year end; that is our current target.

As it relates to the elections, the market currently favors the incumbent.  When the market earns more than 8% on the year of the election, the incumbent has been successful in keeping the office 85% of the time.  So the trend is the friend for Obama.  If he were to lose in November, it would be a break of the presidential/stock market trend.