One Tier and Rubble Down Below
One of the striking things about bull markets is that they often end in confident exuberance, while simultaneously deteriorating from the inside. We’ve certainly observed this sort of selectivity during the past year. The market advance in 2019 fully recovered the market losses of late-2018, fueled by a wholesale reversal of Fed policy, hopes for a “phase one” trade deal, and as noted below, a bit of confusion about what actually constitutes “quantitative easing.”
The Meaning of Valuation
The recent half-cycle has been admittedly difficult. My bearish response to historically-reliable “overvalued, overbought, overbullish” syndromes proved detrimental in the face of zero-interest rate policies that amplified speculation, and we’ve adapted our discipline to give priority to our measures of market internals – which we use to gauge that speculation.
Propositions for a Recessionary Bear Market
As the financial markets enter what I expect to be a rather disruptive completion to the recent speculative half-cycle, it will be helpful for investors to consider certain propositions that are readily available from history, rather than insisting on re-learning them the hard way.
Going Nowhere in an Interesting Way
Not surprisingly, the higher the valuation at the bull market peak, the longer the subsequent period of disappointing returns, in several instances extending more than a decade, though not without intermittent failure-prone bull market rallies to add excitement. This is what I often call ‘going nowhere in an interesting way.’
Warning: Federal Reserve Easing Ahead
Of all the distinctions that investors might make in the coming few years, one that I expect will serve investors particularly well is the distinction between how the market responds to monetary policy when investors are inclined toward speculation, versus how the market responds when investors are inclined toward risk-aversion.
Vulnerable Windows and Swinging Trap Doors
Why do economies collapse into recession in ways that seem so difficult to predict? Why do financial markets collapse into free-fall with timing that’s so loosely related to market valuations? Much of the reason is that complex systems usually aren’t linear.
Why a 60-65% Market Loss Would Be Run-Of-The-Mill
One might view the very comparison of present stock market conditions to 1929 market peak as exaggerated and preposterous, but then, one would be wrong. The fact is that on the valuation measures we find most strongly correlated with actual subsequent long-term and full-cycle market returns across history (and even in recent decades), current market valuations match or exceed those observed at the 1929 peak.
You Are Here
Probably the most useful exercise we can do at present is to examine where the markets and the U.S. economy are in their respective cycles - with 19 charts and detailed analysis. There’s little question that the market is long into what Rhea described as the final phase of a bull market; “the period when speculation is rampant – a period when stocks are advanced on hopes and expectations.”
Ground Rules of Existence
Over the years, I’ve often quoted Galbraith’s remark about the “extreme brevity of the financial memory.” During every speculative episode, investors come to believe that past experience is “the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present,”...
Turtles All the Way Down
Last week, the Federal Reserve issued policy statements intended to telegraph a shift toward easier, or at least more patient monetary policy. Though Wall Street interpreted this shift as a major about-face in the Fed’s policy stance, the most significant shift in Fed Chair Jerome Powell’s statements actually occurred on November 28.
Questions We Hear a Lot
In recent days, we’ve heard a number of analysts gushing that the S&P 500 is vastly cheaper than it was only a few months ago. It’s worth noting that they’re actually referring to an index that is now less than 10% below the steepest speculative extreme in history.
Bubbles and Hot Potatoes
Of all the delusions that have infected the minds of economists, central bankers, and the investing public in recent years, perhaps none is as short-sighted and pernicious as the idea that aggressively low interest rates are “good” for the economy and the financial markets.
The Heart of the Matter
Let’s be clear. October’s market decline was a rather mild warning shot. At its lowest close, the S&P 500 lost -9.9% from its September peak, before rebounding in recent sessions. As I noted during the 2000-2002 and 2007-2009 collapses, intermittent “fast, furious, prone-to-failure” rebounds are among the factors that encourage investors to hold on through the entirety of major declines.
The Music Fades Out
The music is fading out, and a trap-door has opened up in the floor, but they're still dancing. In recent days, the combination of extreme valuations and unfavorable market internals has been joined by acute dispersion in daily trading data that often occurs within a few days of pre-collapse peaks in the market.
Eternal Sunshine of the Spotless Mind
Current stock market capitalization is largely an artifact of speculative psychology, not reasonably discounted cash flows. Unless investors rely on eternal sunshine of the spotless mind – the assumption that current levels of extreme cyclical optimism will be permanent – they should not expect the associated valuation extremes to be permanent either.
Market returns and economic growth have underlying drivers. At their core, extended periods of extraordinary growth and disappointing collapse reflect large moves in those drivers from one extreme to another. Extrapolation becomes a very bad idea once those extremes are reached.
Mind the Trap Door
Even when extreme “overvalued, overbought, overbullish” warning signs are present, we now require explicit deterioration in market internals before adopting a negative market outlook. That, however, is far different than saying that extreme conditions can be ignored altogether. With market internals negative here, underlying market risks may be expressed abruptly, and with unexpected severity.
Hallmark of an Economic Ponzi Scheme
The hallmark of an economic Ponzi scheme is that the operation of the economy relies on the constant creation of low-grade debt in order to finance consumption and income shortfalls among some members of the economy, using the massive surpluses earned by other members of the economy. The factors most responsible for today’s lopsided prosperity are exactly the seeds from which the next crisis will spring.
Comfort is Not Your Friend
The overall profile of market conditions continues to feature: 1) hypervaluation on the measures we find best-correlated with actual subsequent S&P 500 total returns, coupled with 2) continued deterioration in our measures of market internals, which are the most reliable tools we’ve found to gauge the psychological inclination of investors toward speculation or risk-aversion.
Risk-Aversion Meets a Hypervalued Market
Investment is about valuation. Speculation is about psychology. Both factors are unfavorable here. We’re observing the very early effects of risk-aversion in a hypervalued market. Based on the deterioration we’ve observed in our most reliable measures of market internals, investor preferences have subtly shifted toward risk-aversion, which opens up something of a trap-door.
The Arithmetic of Risk
In my view, the idea that higher risk means higher expected return is one of the most dangerous and misunderstood propositions in the financial markets. The reason it’s dangerous is that it ignores the central condition: “provided that one is choosing between portfolios that all maximize expected return per unit of risk.” Presently, the S&P 500 is both a high risk and a low expected return asset.
Measuring the Bubble
I expect the S&P 500 to lose approximately two-thirds of its value over the completion of this cycle. My impression is that future generations will look back on this moment and say "... and this is where they completely lost their minds." As I’ve regularly noted in recent months, our immediate outlook is essentially flat neutral for practical purposes, though we’re partial to a layer of tail-risk hedges.
When Speculation Has No Limits
Here we are, nearly three times the level at which I expect the S&P 500 to complete this cycle. Yet our immediate outlook remains neutral (though tail-risk hedges remain appropriate). It’s essential to distinguish between valuations, which have long-term implications, and market internals, which have implications for shorter segments of the market cycle.
Survival Tactics for a Hypervalued Market
The essential survival tactic for a hypervalued market, and its resolution ahead, is to recognize that market valuations can experience breathtaking departures from historical norms for extended segments of the market cycle, so long as shorter-term conditions contribute to speculative psychology rather than risk-averse psychology. Yet those departures matter enormously for long-term returns.
Three Delusions: Paper Wealth, a Booming Economy, and Bitcoin
Delusions are often viewed as reflecting some deficiency in reasoning ability. The risk of thinking about delusions in this way is that it encourages the belief that logical, intelligent people are incapable of delusion. An examination of the history of financial markets suggests a different view.
Navigating the Speculative Id of Wall Street
Valuations are understood best not by trying to “justify” or dismiss current extremes, but by recognizing that across history, the speculative inclinations of investors have periodically allowed valuations to depart dramatically from appropriate norms, at least for limited segments of the complete market cycle.
Brief Observations: Distinctions Matter
Last week, the uniformity of market internals shifted to an unfavorable condition. During the advancing half-cycle since 2009, zero interest rates encouraged speculation (and maintained favorable market internals) long after extreme overvalued, overbought, overbullish conditions emerged. But distinctions matter. Once the uniformity of market internals - the most reliable measure of speculation itself - is knocked away, those extremes are still likely to matter with a vengeance.
This Time Is Different, But Not How Investors Imagine It Is Different
Encouraged by the novelty of zero-interest rates, not even the most extreme “overvalued, overbought, overbullish” conditions have been enough to derail the speculative inclinations of investors. Yet in every other way, this speculative episode is simply a more extreme variant of others that have come before it.
Why Market Valuations are Not Justified by Low Interest Rates
Current market valuations are consistent with negative expected returns for the S&P 500 over the coming 10-12 years, with a likely market loss of more than -60% in the interim. The proposition that “lower interest rates justify higher valuations” has become a rather dangerous slogan, and is a distressingly incomplete statement that ignores the other half of the sentence: “provided that the stream of expected cash flows is held constant.”
So the mindset, I think, goes something like this. Yes, market valuations are elevated, but, you know, low interest rates justify higher valuations. Besides, there’s really no alternative to stocks because you’ll get what, 1% annually in cash? Look at how the market has done in recent years. There’s no comparison.
Eyes Wide Shut
At the October 2002 market low, the S&P 500 stood -49.2% below its March 2000 peak (-48.0% including dividend income), with the Nasdaq 100 having lost more than -82.8% from its high, on the basis of both price and total return. The loss wiped out the entire total return of the S&P 500, in excess of Treasury bills, all the way back to May 1996.
Behind the Potemkin Village
The main contributors to the illusion of permanent prosperity have been decidedly cyclical factors. Investors presently appear to be taking past investment returns and economic growth at face value, without considering their underlying drivers at all. My impression is that while the U.S. may very well encounter credit strains or other economic dislocations in the coming years...
Valuations, Sufficient Statistics, and Breathtaking Risks
Current extremes present what I view as one of the three most important opportunities in history to defend capital. My sense is that many investors will squander this opportunity until yet another bubble implodes.
The Conceit of Central Bankers and the Brief Illusion of Wealth
The belief that Fed-induced speculation creates “wealth” is a conceit that rests on the delusion that “wealth” is embodied in the price of an asset, rather than the stream of cash flows it delivers over time.
Imaginary Growth Assumptions and the Steep Adjustment Ahead
Within a small number of years, investors are likely to discover that they have allowed their assumptions about growth in U.S. GDP, corporate revenues, earnings, and their own investment returns to become radically misaligned with reality, and that Wall Street’s justifications for the present, offensive level of equity market valuations are illusory. Based on outcomes that have systematically followed prior valuation extremes, the accompanying adjustment in expectations is likely to be associated with one of the most violent market declines in U.S. history, even if interest rates remain persistently depressed.
Broadening Internal Dispersion
We extract signals about the preferences of investors toward speculation or risk-aversion based on the joint and sometimes subtle behavior of numerous markets and securities, so our inferences don't map to any short list of indicators. Still, internal dispersion is becoming apparent in measures that are increasingly obvious.
Estimating Market Losses at a Speculative Extreme
In my view (supported by a century of market cycles), investors are vastly underestimating the prospects for market losses over the completion of this cycle, are overestimating the availability of “safe” stocks or sectors that might avoid the damage, and are overestimating both the likelihood and the need for some recognizable “catalyst” to emerge before severe market losses unfold.
Hot Potatoes and Dutch Tulips
At the height of the technology bubble, the median of the most reliable market valuation measures we follow (those most strongly correlated with actual subsequent S&P 500 total returns) briefly reached an apex 178% above historical norms that had been regularly approached or breached over the completion of every market cycle in history.
Fully 1.4% of the 2.0% average annual real GDP growth observed since the beginning of 2010 has been driven by growth in civilian employment. As slack labor capacity has slowly been reduced, the unemployment rate has dropped from 10% to just 4.4%. That jig is up.
Mesas, Valleys, Plateaus, and Cliffs
We are at the far edge of a monumental mesa here, but speculators are ignoring the cliff, assuming that they are on a permanently high plateau. The unfortunate aspect of these mesas and valleys is that they encourage backward-looking investors to believe that projected returns based on “old valuation measures” are no longer relevant, precisely when valuations are most informative about future returns.