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As S&P 500 nears peak, investors should ponder two prior asset bubbles

Will the third time be the charm?

The S&P 500 has made two previous assaults on the 1,600 level since 1995 only to fall back each time.

The world's most widely followed stock market benchmark now stands at about 1,560 – remarkably close to the 2000 peak of 1,527.46 and the 2007 high of 1,565.

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While the current rise may yet prove to be more durable than its predecessors, there's ample reason for concern. At least one high-profile observer sees the market entering a multiyear period in which big swings will be the norm.

Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis, delivered a speech last week in which he suggested that the current central-bank-led equity rally may be running out of steam.

Speaking at the Hyman Minsky Conference, Mr. Kocherlakota projected a slow-growth, highly volatile investment backdrop with ominous implications for equity investors.

Mr. Kocherlakota noted that despite the enormity of Fed monetary support, the central bank's policies have failed to spark a strong economic recovery: "The outlook for both employment and prices is too low relative to the [Fed]'s goals." He expects the extremely low-interest-rate policy to continue for five to 10 years.

The low-interest-rate environment will be characterized by investors "bidding up the price of long-lived assets –including gold, land, stocks or machines." Furthermore, "the second consequence of low real interest rates is that asset returns should be expected to be highly volatile."

The strongly rising prices in these asset classes during the past few months suggests the bidding-up process may already be behind us. The top-performing investment strategies since the rally began in 2009, notably resources, look increasingly exhausted.

Investors are still dealing with last week's swoon in gold prices. Meanwhile, CNBC reports that the five-year rally that pushed the price of Iowa farmland to $8,700 ( U.S.) per acre from $2,275 is increasingly threatened by a falling corn price. And the share price of Caterpillar Inc., a proxy for global demand for machinery, has fallen 42 per cent from its 2012 highs, with the company posting disappointing results on Monday.

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Over the past two decades, each major sector of the U.S. economy – business, consumers and government – has taken its turn attempting to push the index through the seemingly impenetrable 1,600 resistance level.

The first attempt, during the tech bubble, was spurred by corporate spending.

"Real non-residential private investment increased at an annualized rate of more than 12 per cent between the beginning of 1996 and the middle of 2000," reports Matthew Klein of Bloomberg. "That changed once firms realized that they had been wasting their money. … Capital expenditures plummeted by nearly 20 per cent between the middle of 2000 and the end of 2001."

The second try, during the 2000-to-2007 U.S. real estate boom, was led by households. Mortgage debt climbed 127 per cent to $10.6-trillion between 2000 and 2009 and revolving credit – largely credit cards – jumped 66 per cent to $10.2-trillion in the same period.

Now it's the Fed's turn to borrow and spend. Investors can hope that the central bank's infinite firepower will drive the S&P 500 permanently through 1,600.

But they should keep the market's previous highs in mind. In 2000, it was telecommunications networks and in 2007 it was housing that drove stocks upward. Each time, investors realized that too much had been built with easily borrowed funds when the S&P 500 was almost exactly where it is now.

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This time, unlike the past two market peaks in 2000 and 2007, there is no single asset class that is obviously overpriced – an optimistic sign. But with popular asset classes, particularly precious metals and resources, flagging and recent economic data at alarmingly weak levels, Mr. Kocherlakota's warning about the volatility to come takes on added significance.

Investors should play it safe. It's prudent to take profits in areas, such as precious metals and high-yield corporate debt, that have had winning track records in recent years. And, with market risks swinging toward slower growth rather than inflation, keeping more of your wealth in cash and government bonds looks like a great idea until the smoke clears.

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About the Author
Market Strategist

Scott Barlow is The Globe's in-house market strategist. He is a 20-year veteran of Canadian investment banks, including Merrill Lynch Canada, CIBC Wood Gundy and Macquarie Private Wealth (MPW). He was a highly ranked mutual fund analyst for 10 years and then, most recently, the head of a financial adviser support team at MPW. More


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