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Here's what could pop the stock-market bubble

Bubble soccer
Carlos Osorio | Toronto Star | Getty Images

It is finally going to be a make or break earnings season for stocks. This is because the justification for record high stock prices that have been perched atop extremely stretched valuation metrics has been the following false assumptions: The hope that the Federal Reserve will not resume its interest-rate hiking cycle, the U.S. dollar stops rising, the price of oil enters a sustainable bull market and long-term interest rates continue to fall.

If all those conditions were in place, investors could continue to believe a turnaround in the anemic 2-percent GDP growth endured since 2010 was imminent. And, most importantly, that a reversal of the five straight quarters of negative earnings on the S&P 500 might be just around the corner. But even if they were perpetually disappointed in growth and earnings that didn't materialize, they could always afford to wait until the next quarterly earnings report because there just wasn't any alternative to owning stocks.

However, if earnings come in weak for the current quarter — which would be the sixth quarter in a row — that disappointment would occur in the context of a rising U.S. dollar, falling commodity prices, spiking long-term interest rates and a Federal Reserve that will most likely resume its hiking cycle in December. In other words, it would be game over for the equity bubble.

After all, market pundits have placed nearly all of the blame for the negative earnings string on a crashing oil price and a spiking U.S. dollar. However, during the third quarter, the WTI Crude price and the dollar were both very stable. And the price of crude was trading in the mid-$40 a barrel range for both the third quarter of 2015 and the third quarter of 2016. Therefore, if earnings don't bounce back now how can they be expected to improve in the fourth quarter and beyond, especially while the Fed re-commences its hiking cycle, which should cause the dollar to rise and commodity prices to fall once again?


"The free pass on overhyped stock valuations is now over. And with the S&P 500 trading at 25x reported earnings, this market needs a huge revenue and earnings rebound in the third quarter or the gravitational forces of rising interest rates will send stock prices significantly lower."

So how does the earnings season look so far? Industrial and metals giants such as Honeywell, Dover Corporation, PPG, Alcoa and United Technologies have all missed and/or warned on earnings for the third quarter. In the case of worldwide lightweight metals producer Alcoa, (the stock is down nearly 20 percent since its earnings report) not only missed bottom-line expectations but revenue fell by 6 percent year over year, which indicates the lack of global growth and demand for industrial metals. Multinational industrial giant Honeywell's CEO Dave Cote said last week that Jet engine service orders, scanners, and logistic and shipping services simply failed to materialize in September. His warning and comments sent the shares down more than 7 percent last Friday. The company further sited worsening growth in the Middle East, Russia and China. In addition, this slowdown in GDP growth worldwide was illustrated in trade data from China, which showed September exports fell 10 percent in dollar terms from a year earlier.

The free pass on overhyped stock valuations is now over. And with the S&P 500 trading at 25x reported earnings, this market needs a huge revenue and earnings rebound in the third quarter or the gravitational forces of rising interest rates will send stock prices significantly lower.

The low on Treasury yields is most likely behind us. In fact, the 10-year note yield has risen from 1.36 percent in July to 1.8 percent recently. Indeed, interest rates are rising across the globe as central bankers now believe higher long-term rates and a steeper yield curve are necessary for a healthy banking system. And the Fed has similarly duped itself into believing asset prices are not in a bubble and that borrowing costs can normalize without hurting equity prices and economic growth. However, both assumptions are extremely far removed from reality.

The truth is that this protracted economic and earnings malaise — that shows no sign of turning around — coupled with record high stock prices and the reversal of a nearly decade-long zero interest policy on the part of the Fed, points to a collapse in equity, bond and commodity prices concurrently. The reversal of the central bank's trickle-down wealth effect could very easily cause a recession to hit the economy hard by the middle of 2017.

Last December, the Fed's liftoff from ZIRP sent stock prices tumbling over 10 percent — for their worst start of a year in its history. Investors still have time avoid a similar outcome.



Commentary by Michael Pento who produces the weekly podcast "The Mid-week Reality Check," is the president and founder of Pento Portfolio Strategies and author of thebook "The Coming Bond Market Collapse."

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