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.
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.
Put simply, with market internals unfavorable and interest rates off the zero bound, the two main supports that made the half-cycle since 2009 “different” have already been kicked away.
The Fed does not have to make guesses about exactly what is required to normalize its balance sheet, except to the extent that it ignores a century of evidence.
The characteristic feature of a bubble is that the long-term return implied by discounted cash flows becomes detached from the higher, temporarily self-reinforcing return that is imagined by investors. As a result, the bubble component accounts for an increasingly large proportion of the total price, and becomes progressively vulnerable to collapse. It is in this precise sense that the current speculative episode can be characterized as a bubble, just as I (and Modigliani) characterized the bubble that ended in 2000.
Overall, my impression remains that the market is in the process of tracing out the blowoff finale of the third speculative financial bubble since 2000. Still, as is true for the market cycle as a whole, the broad outline of this top formation is likely to be shaped by three factors: 1) valuations, which primarily affect total market returns over a 10-12 year horizon, as well as the magnitude of potential losses over the completion of the market cycle; 2) the uniformity or divergence of market internals across a broad range of stocks and security-types, which remains the most reliable measure we’ve identified of the psychological preference of investors toward speculation or risk-aversion (when investors are inclined to speculate, they tend to be indiscriminate about it); and 3) overextended market action highlighting extremes of speculation or fear - in the advancing portion of the market cycle, these are best identified by syndromes of overvalued, overbought, overbullish conditions.
It’s precisely the failure of valuations to matter over shorter segments of the market cycle that regularly convinces investors that valuations don’t matter at all
My friend Mark Hulbert once had a philosophy professor at Oxford, who distinguished two ways of being wrong: “You can be just plain wrong, or you can be wrong in an interesting way.” In the latter case, Mark explained, correcting the wrong reveals a lot about the underlying truth.
When investors pay high P/E multiples on earnings that already reflect cyclically-elevated profit margins, they pay twice for their investment.
Every episode in history has its own wrinkles. But investors should not use some “new era” argument to dismiss the central principles of investing, as a substitute for carefully quantifying the impact of those wrinkles. Unfortunately, because investors get caught up in concepts, they come to a point in every speculative episode where they ignore the central principles of investing altogether.
Despite extreme valuations, investors’ fear of missing out is looking increasingly desperate. In market cycles across history, that has been an unfortunate impulse.
One way to use information on stock valuations and interest rates in a systematic way is to estimate the break-even level of valuation that would have to exist at given points in the future, in order for stocks to outperform or underperform bonds over various horizons. Investors presently face a dismal menu of expected returns regardless of their choice. Indeed, in order for expected S&P 500 total returns to outperform even the lowly return on Treasury bonds in the years ahead, investors now require market valuations to remain above historical norms for the next 22 years.The good news is that this menu is likely to improve substantially over the completion of the current market cycle. The problem is that current valuation extremes present a hostile combination of weak prospective return and steep risk.
One of the benefits of historically-informed investing is that it allows various investment perspectives to be evaluated from the standpoint of evidence rather than verbal argument. That’s particularly important during periods like today, when much of financial commentary on Wall Street can be filed into a folder labeled “it’s hard to argue with your logic, if only your facts were actually true.”
Put simply, investors are in an echo chamber here, where their optimism about economic outcomes is largely driven by optimism about the stock market, and optimism about the stock market is driven by optimism about economic outcomes. Given the deterioration in correlations between “soft” survey-based economic measures and subsequent economic and financial outcomes, investors should be placing a premium on measures that are reliably informative. On that front, hard economic data, labor force constraints, factors influencing productivity (particularly gross domestic investment and the position of the current account balance in the economic cycle), reliable valuation measures, and market internals should be high on that list.
Imagine driving a car moving down the road at 20 miles an hour. You hold a rope out the window. At the other end of that rope is a skateboard. If the skateboard is behind the car, yanking the rope pulls the skateboard forward, so the skateboard might temporarily speed ahead until it gets way ahead of the car and the rope tightens again.
Over the completion of the current market cycle, we estimate that roughly half of U.S. equity market capitalization - $17 trillion in paper wealth - will simply vanish. Nobody will “get” that wealth. It will simply disappear, like a game of musical chairs where players think they've won by finding chairs as the music stops, and suddenly feel them dissolving as if they had never existed in the first place.
Presently, based on the most historically reliable valuation measures we identify, we expect annual total returns for the S&P 500 averaging just 0.6% over the coming 12-year period; a prospective return that we expect will not only underperform bonds over this horizon, but even the lowly yields available on risk-free T-bills.
During the later part of the roaring 20’s, Irving Berlin wrote “Blue Skies,” which captured some of the optimism of the era that preceded the Great Depression. Unfortunately, untethered optimism is not the friend of investors, particularly when they have already committed their assets to that optimism, and have driven valuations to speculative extremes.
"The issue is no longer whether the current market resembles those preceding the 1929, 1969-70, 1973-74, and 1987 crashes. The issue is only - are conditions like October of 1929, or more like April? Like October of 1987, or more like July?
As Benjamin Graham observed decades ago, "Speculators often prosper through ignorance; it is a cliche that in a roaring bull market, knowledge is superfluous and experience is a handicap. But the typical experience of the speculator is one of temporary profit and ultimate loss."
If there’s any point in U.S. stock market history, next to the market peaks of 1929 and 2000, that has deserved a time-stamp of speculative euphoria that will be bewildering in hindsight, now is that moment.
Investors and even financial professionals rarely recognize asset bubbles while they are in progress. As the price of a financial asset rises, investors have an increasing tendency to use the past returns and the past trajectory of the asset as the basis for their future return expectations.
There are moments when one has the responsibility to speak if one has a voice.
The key to drawing useful information out of noisy data is to rely on multiple “sensors.” Alone, each sensor may capture only a small portion of the true signal, and may not be greatly useful in and of itself. The power comes when the sensors are used together in order to distinguish the common signal of interest from the surrounding noise.
One of the attempted barbs tossed my way at various points in the past 20 years is “Cassandra.” Frankly, I kind of like it.
Outcomes are not independent of initial conditions. While there are certainly policy shifts that could encourage greater productive investment and raise the long-run trajectory of economic growth, no shift in economic policies is likely to produce rapid, sustained economic growth in the next few years because the underlying factors that drive rapid, sustained growth aren’t presently in a position to support it.
When investors are euphoric, they are incapable of recognizing euphoria itself.
Nearly all of the variation in GDP growth over time is explained by the sum of employment growth plus productivity growth.
Don’t be lulled into complacency by thinking that severely hostile market conditions have to resolve into immediate market losses. That’s not the way these environments work, and they never have.
The stock market has reestablished an extreme overvalued, overbought, overbullish syndrome of conditions that - unlike much of half-cycle advance from 2009 to mid-2014 - lacks internal uniformity, particularly among interest-sensitive and globally-sensitive sectors.
My sense is that investors are exuberant to have a new theme, any theme, other than watching the Federal Reserve.
If you net out all the assets and liabilities in an economy, you’ll find that the nation’s accumulated stock of real investment is the only thing that remains.
Short-term oversold conditions offer a sense of potential knee-jerk dip-buying behavior, but the conviction of that behavior is often fairly weak and short-lived.
My continued impression is that the global equity markets broadly peaked in the second-quarter of 2015, and that the more recent marginal U.S. highs in August were a “throwover” in response to the post-Brexit plunge in global interest rates.
Put simply, it’s not valuation norms that have increased, but instead the willingness of investors to repeatedly chase stocks to valuation levels that remain associated with predictably dismal subsequent outcomes.
Several weeks ago, we shifted from a rather neutral near-term stock market view, to a hard-negative outlook, based on fresh deterioration in various trend-sensitive components within our broad measures of market action.
Historically, the best opportunities to boost market exposure emerge when a material retreat in valuations is joined by an early improvement in market action. At present, exactly the opposite is true. Extreme valuations and compressed risk-premiums have been joined by deterioration in market internals. This deterioration is an indication of growing risk-aversion among investors. Much of the recent bubble has been driven by yield-seeking, trend-sensitive speculators, with value-conscious investors progressively stepping back. As a result, any coordinated attempt by trend-sensitive market participants to exit by selling stock is unlikely to be met by demand from value-conscious investors at prices anywhere near present levels. This, in turn, leaves the market vulnerable to potentially abrupt losses.
Every financial bubble rests on the presumption that there is still some greater fool available to purchase overvalued assets, no matter how overvalued they might become. In the recent half cycle, central banks have intentionally extended this speculation by promising that they, themselves, could be relied upon to be those greater fools.
