Among the most persistent questions I hear is why we don’t just adapt to the reality that the Federal Reserve will never again “allow” the market to experience a serious decline. The problem with this view is that it rests on the premise that Federal Reserve policy supports the market in a clear-cut and mechanical way, when its effectiveness actually relies on the speculative psychology of investors.
A remarkable feature of extended bull markets is that investors come to believe – even in the face of extreme valuations – that the world has changed in ways that make steep market losses and extended periods of poor returns impossible.
The title of this comment may seem odd, given that – as I write this on July 14, 2021 – the S&P 500 is at a record high.
Coherent thinking is interested in how things are related; where they come from, where they go, and the mechanisms by which they affect each other.
There’s an old bit of advice that one shouldn’t count one’s chickens before they’re hatched.
From 1949 through 1964, the S&P 500 enjoyed an average annual total return of 16.4%. In the 8 years that followed, through 1972, the total return of the index averaged a substantially lower 7.6% annually; strikingly close to the 7.5% projection that Graham had suggested based on prevailing valuations, yet still providing what Graham had suggested would likely “carry a fair degree of protection” against inflation, which averaged 3.9% over that period.
The word “bubble” is tossed around quite a bit in the financial markets, but it’s rarely used correctly.
Nothing so animates a speculative herd as a parabolic price advance in an asset detached from any standard of value. I am convinced that future generations will use the present moment to define the concept of a reckless speculative extreme, in the same way our generation uses “1929” and “2000.”
The speculative “V” is one of the most interesting and challenging features of the market cycle. For passive investors, it can be a period of exhilaration followed by panic.
I should start by saying that I’ve got great admiration for Robert Shiller. Even three decades ago when I was completing my doctorate at Stanford, I avidly embraced his work, including his studies on excess volatility. He has originated an impressive range of useful tools, including the Case-Shiller housing price indices. As the tech bubble was peaking in 2000, I doubt that any 30-something in finance was more pleased to see Shiller become a widely-quoted figure in the financial markets. All of that is important to say, before I tear into this particular metric.
One of the most insidious ideas foisted on investors by Wall Street, in tacit cooperation with activist policy makers at the Federal Reserve, is the fiction that zero interest rates offer investors “no alternative” but to speculate in risky securities.
In calling the current market the third “Real McCoy” bubble of recent decades, Jeremy Grantham described, in his own words, what I call the Iron Law of Valuation: a security is nothing more than a claim on some set of future cash flows that investors expect to be delivered into their hands over time. The higher the price an investor pays today for some amount of cash in the future, the lower the long-term return the investor can expect on that investment.
Here in the U.S., I estimate that the actual number of people infected by SARS-CoV-2 to-date is currently just over four times the number of reported cases. Actual cases are undercounted partly because, based on very large-scale, unbiased testing, roughly 45% of people who acquire SARS-CoV-2 infection are asymptomatic.
You know it’s a bubble when you have to edit the Y axis on all of your charts because valuations have broken above every historical peak, and estimated future market returns have fallen beyond the lowest points in history, including 1929.
About two-thirds of this month’s comment is about COVID-19 and the risk of a second wave. This is not only for the sake of public health, which would be enough, and not only to contribute to a better understanding of the epidemic.
Saying that extreme stock market valuations are “justified” by low interest rates is like saying that poking yourself in the eye is “justified” by smashing your thumb with a hammer.
Severe economic recessions often feature what might be called an “incubation phase,” where an exuberant rebound from initial stock market losses becomes detached from the quiet underlying deterioration of economic fundamentals and corporate balance sheets.
A compassionate society has both economic reason and ethical responsibility to provide a social safety net to its most vulnerable members. It is an act of both economic insanity and ethical corruption to provide a financial safety net to its most reckless speculators.
Amid the current crisis, a forceful economic policy response is essential. The central principle here is that the closer we can get economic support to the point where current spending enters the “circular flow” – basic incomes, net rent and lease obligations, utilities, contractual payments, even net interest payments, the better we can support the entire economy.
I expect that the most valuable aspect of our investment discipline over the completion of this cycle will be our ability and willingness to flexibly respond to changes in observable market conditions as they emerge.
From a full-cycle perspective, the decline in the U.S. stock market from its recent high remains something of a non-event, compared with the probable market loss over the completion of this cycle.
There are two key drivers of investment returns. One is valuations, which provide a great deal of information about long-term investment prospects, and about the income component of total returns. The other is the uniformity or divergence of prices across thousands of individual securities, which helps to distinguish whether shorter-term investor psychology is inclined toward speculation or risk-aversion.
Understand this. The more glorious this bubble becomes in hindsight, the more dismal future investment returns become in foresight. The higher the price investors pay for a set of future cash flows, the lower the return they will enjoy over time. Whatever they’re doing, it’s not “investment.”
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 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.
By the time a bull market reaches its peak, investors have experienced numerous instances where the market has declined by several percent, followed by an advance to fresh highs.
One of the pitfalls of identifying market conditions using labels like “bull market” and “bear market” is that the accuracy of those labels can only be verified in hindsight.
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.
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.’
What distinguishes an overvalued market that continues to advance from an overvalued market that often drops like a rock? In my view, it’s the psychological disposition of investors toward speculation or risk-aversion.
While investors appear exuberant about the prospect for Fed easing, they seem largely unaware that initial Fed easings have almost invariably been associated with U.S. recessions. They’re running toward the fire.
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.
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.
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.
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.”
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,”...
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.
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.
Given the steep market decline in recent days, short-term market conditions clearly qualify as “oversold” and highly compressed, in my view.
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.
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 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.
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.
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.
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.
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.
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.
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.
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.
