The S&P 500 racked up another fine quarter with an 8.55% return which brought the gains for the first half of the year to 15.25%. It has been easy to fill in the blanks with ostensible reasons for the continued appreciation: Strong economic growth, easy financial conditions, receding threat of Covid-19, etc. Still, it is hard to imagine the abyss the market was staring into just sixteen months ago.
This paradoxical combination of frightening crashes and eye-watering rebounds has come to dominate market behavior over the last several years. This pattern also differs noticeably from the past when markets traced out the business cycle more closely. The challenge for investors is to find a mental model that can help navigate this unfamiliar territory.
We’re not in Kansas any more
As value investors are well aware, valuation does not make a great timing tool, but it is closely associated with future returns and therefore has proved useful for long-term positioning. Since the financial crisis, however, not only has value underperformed consistently, but other investment tools have lost effectiveness as well. John Hussman recently described:
“In market cycles across a century of market history, there was always a ‘limit’ to speculation
– points where overvalued, overbought, overbullish syndromes were so extreme that an air pocket, or panic, or crash would regularly follow. Quantitative easing made those ‘limits’ utterly unreliable …”
So, if past guidelines to speculative limits have become ineffective, what guidelines should investors turn to? As it turns out, authors Tim Lee, Jamie Lee, and Kevin Coldiron pursued a similar course of inquiry in their book, The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis. For example, they wanted to know …
“Why have stock markets, over the past 25 years, experienced huge rises and crashes? Why did the US stock market, in particular, quadruple over the years following the 2007–2009 global financial crisis even though US economic performance was at best so-so?”