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How Much More Extreme Can Markets Get?

May 31, 2015

How Much More Extreme Can Markets Get?

These charts help us understand that a top is not just price, but a reversal in extremes of margin debt, valuation and sentiment.

In blow-off tops, extremes of valuation, complacency and margin debt can always shoot beyond previous extremes to new extremes. This is why guessing when the blow-off top implodes is so hazardous: extreme can always get more extreme.

Nonetheless, extremes eventually reverse, and generally in rough symmetry with their explosive rise. Exhibit 1 is margin debt: NYSE Margin Debt Hits a New Record High (Doug Short)

Note the explosive rise in margin debt in the past few months:

At tops, soaring margin debt no longer pushes stocks higher. I’ve marked up an excellent chart by Doug Short to highlight the diminishing returns of more margin debt at tops.

It’s clear this same dynamic of diminishing returns is in play now, as margin debt has skyrocketed while the S&P 500 has remained range-bound, with each new high being increasingly marginal.

Exhibit 2 is China’s Shenzhen stock exchange. The price-earnings ratio (PE) is a useful gauge of sentiment: when sentiment reaches extremes of euphoria, PEs go through the roof:

 

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