Three signs the equity-bubble grenade will pop

The recent stock-market volatility has caused the major averages to lose nearly all their gains for 2015. However, it is clear stock prices are still extremely overvalued by virtually every metric, especially when viewed in the absence of GDP and earnings growth.

Closeup of hand grenade
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For starters, the cyclically-adjusted PE ratio on the S&P 500 is currently 27, whereas the normal level for this longer-term valuation metric is just 15. Also, the ratio of total market cap to GDP is currently at 125 percent. This reading, which measures the value of all stock prices in relation to the economy, is the second highest in history outside of the tech bubble and is far above the 110 percent witnessed in 2007. And with a median PE ratio of all NYSE stocks at a record high 22, there can't be any doubt that stock prices are at extreme valuations.

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But these lofty valuations sit atop negative earnings growth and a faltering economy. The Atlanta Fed's GDP model currently shows first-quarter 2015 economic growth will come in at a paltry 0.2 percent annualized rate. And S&P Capital IQ predicts first-quarter earnings will fall 2.9 percent, while also projecting second-quarter earnings growth will contract 1.8 percent.

So how can stock prices remain at record high valuations; given the fact such levels seem egregiously ridiculous within the context of no growth? The answer is simply that central banks have given investors no other alternatives. Banks pay you zip on your deposits and sovereign debt offers little return — even when going out 10 years on the yield curve.

Central banks have forced investors to play musical chairs with their money; but this dangerous game has millions of players and just a handful of chairs. When the music finally stops investors will find that bids for stocks have become very rare.

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There are three very specific conditions that will warn investors when a spike is about to be driven through this massive equity bubble—and, if heeded, will give you a chance to pounce on one of those few remaining bids for stocks at these incredible levels.

1) A U.S. recession. To be clear, domestic growth in the first quarter will already be close enough to zero to get us halfway to a recession. The carnival barkers on Wall Street have jumped on the weather excuse once again and have bought the markets of few more weeks. However, once April economic data are announced, it must clearly display to investors that first quarter's flat GDP print was simply caused by another cold winter. If it does not, the negative earnings growth in the first quarter will then be extrapolated to the second quarter and will convey to investors that the Federal Reserve was unsuccessful in providing sustainable growth after 7 years of zero interest-rate policy. Now that quantitative easing is no longer levitating stocks (and the Fed is actually threatening to raise interest rates), the markets will finally succumb to the massive weight of record-high valuations that have been erroneously built on top of anticipated rapid growth that never materialized. If April's data on durable goods, industrial Production, factory orders or retail sales is reported with a minus sign, investors should run for the exit.

2) If the Fed actually starts raising rates. Of course, some pundits will be quick to point out that just one quarter-point rate hike won't be enough to derail the equity bubble because rates will still be very low. However, the Fed will be embarking on a rate-hike campaign into a market cycle of deflation and slowing growth. Normally, the Fed raises rates to combat inflation, which has started to send long-term rates much higher. But, this time around, the Fed will be hiking rates just to prove it can get off the zero-bound range it has been stuck on since 2008. Or, because the unemployment rate dropped below the Fed's arbitrary, Phillips-curve line in the sand, where inflation is supposed to magically materialize. This means the 10-year note, which has already dropped below 2 percent due to deflationary forces, would most likely fall even lower. Since the effective Fed-funds rate is currently at 0.12 percent, it will only take a handful of quarter-point rate hikes before the yield curve flattens out and banks find it unprofitable to make new loans. Once this occurs, the money supply contracts and the markets and economy go into a tailspin. Unless the Fed makes it abundantly clear that its first rate hike is not part of any protracted campaign, look for investors to quickly anticipate an inverted yield curve and to start panicking out of stocks.

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3) If U.S. benchmark interest rates were to rise above 3 percent. This could occur if the Fed is finally successful in creating inflation. Or, more likely, when investors lose confidence in the U.S. to easily service the debt. Total non-financial debt has surged $9.5 trillion (30 percent) since 2007. Any significant increase in borrowing costs would quickly derail the fragile consumer who is already suffering from a lack of real income growth. And, increased borrowing costs for the U.S. government would lead to much higher budget deficits. A 10-year note that eclipses 3 percent would quickly topple the fragile real- estate market and also begin to offer significant competition for stocks. The last time U.S. rates spiked above 3 percent from 1.5 percent was April 2013 to January 2014. And this was the real cause for GDP growth to fall to minus 2.1 percent in the first quarter — not the weather.

Until one of these conditions are met, the markets may continue to surge further into record-bubble territory. However, investors should pay close attention to April's economic data, the Fed's strategy surrounding its first rate hike, and also keep a close eye on the long end of the yield curve. That is, if they want to avoid getting consumed by the third massive collapse in equity prices since 2000.

Michael Pento is the president and founder of Pento Portfolio Strategies. He also produces the weekly podcast "The Mid-week Reality Check" and is author of the book "The Coming Bond Market Collapse."