Imagine the collapse of an extended speculative tech bubble, resulting in a broad economic recession. Imagine if the Federal Reserve had persistently slashed short-term interest rates during the downturn, to no avail, leaving rates at just 1% by the time the S&P 500 had lost half of its value and the Nasdaq 100 collapsed by 83%. Imagine that the Fed kept rates suppressed, in the initially well-meaning hope of encouraging lending, growth and employment. Imagine that the depressed level of interest rates made investors feel starved for yield, and drove them to look for safe alternatives to Treasury bills.

Last week, the 10-year Treasury yield dropped to just 1.6%. Technician Walter Murphy noted that his index of global 10-year yields also plunged to an all-time low. The overall structure of global bond yields is undoubtedly the outcome of years of aggressive monetary easing, though the break to fresh lows among European bank stocks may convey some additional information content. Of course, the compression of prospective investment returns isn’t limited to bonds. On the basis of the valuation measures best correlated with actual subsequent S&P 500 total returns across history, prospective 10-12 year S&P 500 nominal total returns have declined to just 0-2% by our estimates, with negative real expected returns on both horizons.

Once extreme valuations are in place, the losses that follow have everything to do with that overvaluation, and nearly nothing to do with the behavior of interest rates. Indeed, the worst market losses across history have been associated with relatively low short-term interest rates during the collapse and the absence of any material hike in interest rates at all as the collapse unfolds. Investors have convinced themselves to tolerate historic valuation extremes, confident that stocks can’t fall unless interest rates rise. They’ve walked right into this setup because they don’t recognize it, and neither central bankers nor the investment profession appear interested in admitting the increasingly pressing risks that they themselves have been complicit in creating.

Ultimately, the intentional encouragement of speculation by central banks in recent years has created a situation from which no resolution is possible other than 0-2% investment returns on a 10-12 year horizon, and a market collapse over the completion of the current market cycle.

We currently estimate that the total return on a conventional portfolio mix of stocks, bonds and Treasury-bills is likely to average scarcely 1.5% annually over the coming decade. Ironically, however, the advance to extreme valuations (and correspondingly poor long-term return prospects) has encouraged pension administrators to underfund future liabilities, on the belief that high realized past returns are representative of future outcomes.

Does anyone really believe that extreme yield-seeking has not already played out in the stock and bond markets? When investors say “there’s no alternative” to overpriced, risky assets, do they not recognize that virtually every investor on the planet has acted on that same belief? Do they not recognize that the absence of yield on short-term money is exactly why stocks and bonds are now also priced to deliver next to nothing over the coming 10-12 years? Do they not recognize that past realized returns have stolen from future prospective returns? Do they not understand that for future prospective returns to normalize even moderately over the completion of the current market cycle (as they have done over the completion of every market cycle in history), much of those past realized returns must be wiped out?

The greatest danger comes when investors insist on speculating even after market internals have deteriorated and momentum has rolled over. Following a long period of speculative success, they may be tempted to ignore latent risks, and to keep speculating on the time-delay between the emergence of latent risks and their abrupt expression. They fall victim to the delusion that, in the words of Citigroup’s Chuck Prince just before the global financial crisis, “as long as the music is playing, you’ve got to get up and dance.” No, you don’t.

Market conditions continue to be characterized by the likelihood of extremely poor long-term and full-cycle outcomes, with expected 10-12 year estimated S&P 500 nominal total returns in the 0-2% range, negative expected real returns on both horizons, and the continued likelihood of a 40-55% interim market loss over the completion of the current cycle; a decline that would represent only a typical run-of-the-mill cycle completion, based on valuation measures most tightly related with actual subsequent market returns across history.

The worst market declines typically emerge from conditions where value-conscious investors have been defensive for quite some time, and where trend-following speculators have been rewarded for quite some time.

Speculators seem willing to imagine that the Fed has created a permanently high plateau, but historically-informed investors should know better.

The single most important quality that investors can have, at present, is the ability to maintain a historically-informed perspective amid countless voices chanting “this time is different” and arguing that long-term investment returns have no relationship to the price that one pays.

The danger of constant fire suppression is that it fosters the illusion that the entire forest is a controllable object, while actually weakening its capacity for resilience. Likewise, the danger of relentless Fed intervention is that it fosters the illusion that the financial markets are under the tight control of monetary policy, while encouraging malinvestment that amplifies the severity of the ultimate consequences. Nothing has been learned from 2000-2002 and 2007-2009, when even persistent and aggressive easing was incapable of holding back the inevitable collapse of malinvestment. The market plunges that completed those market cycles essentially represented the mass recognition by investors that they had badly miscalculated. Each successive bubble encourages them to forget that lesson.

With the S&P 500 Index at the same level it set in early-November 2014, and the broad NYSE Composite Index unchanged since October 2013, the stock market continues to trace out a massive arc that is likely to be recognized, in hindsight, as the top formation of the third financial bubble in 16 years. The chart below shows monthly bars for the S&P 500 since 1995. It's difficult to imagine that the current situation will end well, but it's quite easy to lose a full-cycle perspective when so much focus is placed on day-to-day fluctuations.

When a given behavior stops being reinforced, one might expect the behavior to be abandoned. Instead, and particularly when no substitute behavior is available, you’ll actually see an initial “extinction burst” - a nearly frantic increase in the frequency and the intensity of the behavior. Consider central bankers.

The completion of every market cycle in history has taken the most reliable equity valuation measures toward or below their historical norms - levels associated with subsequent total returns approaching 10% annually. That includes two cycle completions since 2000, as well as cycles prior to 1960 when interest rates regularly hovered near present levels. After an unusually extended speculative half-cycle, we doubt that the completion of the present cycle will be any different. It has taken the third speculative bubble in 16 years to bring the nominal total return of the S&P 500 since March 2000

Last week, the most historically reliable equity valuation measures we identify (having correlations of over 90% with actual subsequent 10-12 year S&P 500 total returns) advanced to more than double their reliable historical norms. When valuations have been near those historical norms, the S&P 500 has generally followed with average nominal total returns of about 10% annually. In contrast, current valuations are associated with expected 10-12 year total returns of about zero, with negative expected returns on both horizons after inflation.

If market internals were to improve markedly (we’re nowhere near that outcome at present), the immediacy of our downside concerns would ease significantly. Here and now, a measurable spike in financial stress has occurred despite an S&P 500 that is still within 10% of its all-time high, but in the context of wicked overvaluation, poor market internals, and weakness in leading economic data. All of those, as I observed at both the 2000 and 2007 peaks, are features that have historically been associated with market collapses. Present conditions don’t imply the forecast of a market crash. But

When a widely-identified support level gives way at rich valuations, in an environment where poor market internals convey a shift toward risk-aversion among investors, the break can behave as a common trigger for concerted attempts to exit.

Historically, increases in the Fed’s balance sheet have only been positively associated with increases in the S&P 500, on average, when the S&P 500 was already in an uptrend and investors were already inclined to speculate.

As we observe in the U.S., central bank easing in Japan only reliably benefits the stock market, on average, when market action is already favorable, indicating a preference among investors to accept market risk. Once market internals deteriorate, central bank easing fails to provoke speculation, on average. The gas pedal is useless when the spark plugs are gone. Aside from short-lived, knee-jerk responses, there is no historical basis to assume that central bank easing will promptly encourage fresh speculation in an overvalued market that has lost internal support. To the contrary, as investo

With extreme valuations coupled with uniformly unfavorable market internals, the market return/risk classification we identify here could not be more hostile. In particular, relief rallies under current conditions tend to be truncated by wicked losses. My use of such strong words here is not hyperbole; it’s a reflection of the skewed return/risk profile that has historically been associated with market conditions similar to those we observe at present.

Since October, the economic evidence has shifted from supporting a growing risk of recession, to a guarded expectation of recession, to the present conclusion that a U.S. recession is not only a risk but an imminent likelihood, awaiting confirmation that typically only emerges after a recession is actually in progress.

Our expectations for a global economic downturn, including a U.S. recession, have hardened considerably in the past few weeks, with a continued expectation of a retreat in equity prices on the order of 40-55% over the completion of the current cycle as a base case. The immediacy of both concerns would be significantly reduced if we were to observe a shift to uniformly favorable market internals. Last week, market conditions moved further away from that supportive possibility.

At speculative extremes, recent history always temporarily belongs to the reckless herd that has ignored concerns about valuation and risk at every turn. Fortunately, the future has always belonged to those who take discipline, analysis, and the lessons of history seriously. On the basis of the valuation measures most strongly correlated with actual subsequent market returns (and that have fully retained that correlation even across recent market cycles), current extremes imply 40-55% market losses over the completion of the current market cycle.

As we look forward to 2016, to following through on our investment discipline over the completion of the current market cycle and beyond, a few recent market comments will serve as a detailed review of our present market and economic outlook.

In recent quarters, I’ve remained adamant that the immediate first step of the Federal Reserve in normalizing monetary policy should have been to reduce the size of its balance sheet. The Fed’s failure to prioritize that first step, in the apparent desire to maintain an aggrandized role in the U.S. financial markets, has significantly increased the risk of a collapse from the speculative extremes the Fed has created in recent years. Given the increasing risk-aversion evident in market internals, we doubt that even a reversal of last week’s rate hike would materially reduce that prospect.

Over the past several years, yield-seeking investors, starved for any “pickup” in yield over Treasury securities, have piled into the junk debt and leveraged loan markets. Just as equity valuations have been driven to the second most extreme point in history (and the single most extreme point in history for the median stock, where valuations are well-beyond 2000 levels), risk premiums on speculative debt were compressed to razor-thin levels. By 2014, the spread between junk bond yields and Treasury yields had fallen to less than 2.4%.

In the presence of obscene valuations, deteriorating market internals, widening credit spreads, and tepid economic activity on the most historically reliable measures, we presently observe the same essential syndrome of risk factors that allowed us to accurately anticipate the 2000-2002 market collapse and recession, as well as the 2007-2009 global financial crisis. Emphatically, a return to risk-seeking behavior among investors, as evidenced by a clear improvement in market internals across a broad range of individual stocks, industries, sectors and security types (including debt securities

The atmosphere is getting thin up here, and every ounce counts triple when you're climbing in rarefied air. While near-term market dynamics are more likely to be impacted by Friday’s employment report than any other factor, our broad view remains that stocks are in the late-stage top formation of the second most extreme episode of equity market overvaluation in U.S. history, second only to the 2000 peak, and already beyond the 1929, 1937, 1972, and 2007 episodes, not to mention lesser extremes across history.

Two types of dispersion are increasingly apparent in market dynamics here. The first type of dispersion is between leading measures of economic activity and lagging ones. The second is dispersion in market internals, particularly observable in a continued narrowing of leadership to a handful of “winner-take-all” stocks, while broader measures of market action across individual stocks, industries, sectors, and credit spreads show persistent divergence that suggests increasing risk-aversion among investors.

Investors have a habit of pointing to past bubbles as if they have actually learned something, even when they are in the midst of another one.

Investors have experienced a great deal of whiplash in recent months. After a rapid but relatively contained retreat in August and September, the stock market has rebounded to within 2% of its May record high. Only weeks ago, investors were concerned about economic deterioration. As of Friday, strength in nonfarm payrolls has suddenly convinced investors that a December rate hike by the Fed is all but certain.

Historically, when the stock market has deteriorated internally following a recent period of overvalued, overbought, overbullish conditions, we know that market outcomes have been negative on average. But what if the S&P 500 Index falls below its 200-day moving average, and then recovers above it again? Doesn’t that recovery signal a resumption of the bull market? The answer largely depends on market internals.

Wide market cycles have been a central feature of the stock market across history. Even a run-of-the-mill bear market decline typically wipes out more than half the gain of the preceding bull market.

One of the central themes I’ve emphasized over the past year is the critical importance of using market internals as a gauge of investor risk-seeking and risk-aversion. Over the long-term, investment returns are driven by valuations – particularly on a 10-12 year horizon. Over shorter horizons, and more limited portions of the market cycle, the primary driver of investment returns is the preference of investors to seek or avoid risk.

One of the important investment distinctions brought out by the speculative episode of recent years is the difference between the behavior of an overvalued market when investors are risk-seeking, and the behavior of an overvalued market when investors shift to risk aversion. The time to be tolerant of bubbles is when the uniformity of market internals provides clear evidence of risk-seeking among investors.

With the S&P 500 within about 8% of its highest level in history, with historically reliable valuation measures at obscene levels, implying near-zero 10-12 year S&P 500 nominal total returns; with an extended period of extreme overvalued, overbought, overbullish conditions replaced by deterioration in market internals that signal a clear shift toward risk-aversion among investors; with credit spreads on low-grade debt blowing out to multi-year highs; and with leading economic measures deteriorating rapidly...

Risk-seeking among investors can often defer the immediate consequences of extreme valuations, while vertical losses can suddenly emerge when extreme overvaluation is joined by increasing risk-aversion among investors (as evidenced by deterioration in broad market internals). In any event, investors should expect market overvaluation or undervaluation to be reliably “worked off” within a period of about 12 years, on average.

Investors who wonder why the stock market failed to advance on the Fed’s decision to leave interest rates unchanged would do well to understand that the market is following a script that has played out repeatedly across a century of market history. The short explanation is straightforward. When investors are risk-seeking (which we infer from the behavior of market internals), Fed easing tends to be very favorable for the stock market, because risk-free, low-interest liquidity is a hot potato to risk-seeking speculators.

When you examine historical data and estimate actual correlations and effect sizes, the dogmatic belief that the Fed can “fine tune” anything in the economy is utter hogwash. Truth, on the other hand, is beautiful. Economic relationships that are supported in real-world data are a sight to behold.

To call the recent market retreat a “crash” is an offense to informed discussion of the financial markets. It was merely an air-pocket of the sort that typically emerges once overvalued, overbought, overbullish conditions are joined with deterioration in market internals. It was probably just a start.

The single most important thing for investors to understand here is how current market conditions differ from those that existed through the majority of the market advance of recent years. The difference isn’t valuations. On measures that are best correlated with actual subsequent 10-year S&P 500 total returns, the market has advanced from strenuous, to extreme, to obscene overvaluation, largely without consequence. The difference is that investor risk-preferences have shifted from risk-seeking to risk-aversion.

Over the years, I’ve observed that overvalued, overbought, overbullish market conditions have historically been accompanied by what I call “unpleasant skew” – a succession of small but persistent marginal new highs, followed by a vertical collapse in which weeks or months of gains are wiped out in a handful of sessions.

When corporations and even developing countries experience debt crises, one of the primary means of restructuring is the debt-equity swap. This sort of transaction involves canceling out debt of the company or government in return for equity of the company, or privatization of some of the assets of the country. Corporate debt-equity swaps typically result in severe dilution of the equity claims of existing shareholders, and in some cases, can wipe those claims out as creditors take control of the company.

“You need to know very little to find the underlying signature of a complex phenomenon…. This is the gift of training and expertise – the ability to extract an enormous amount of meaningful information from the very thinnest slice of experience.” Malcolm Gladwell, Blink

In economics, we often describe “equilibrium” as a condition where demand is equal to supply. Textbooks usually depict this as a single point where a demand curve and a supply curve intersect, and all is right with the world.

As a kid growing up in the 1960’s, I earned my allowance the usual way; cutting grass and raking leaves. When there was no grass to cut or other work to do, my parents – who deeply valued education – would give us things to commit to memory. I figure I squeezed more than 30 bucks out of memorizing the multiplication tables up to 12. My brothers were better at memorizing poetry, but I was pretty good at song lyrics, which put me in good position to learn the words to countless 70's songs (e.g. "This really blew my mind.

“The Nifty Fifty appeared to rise up from the ocean; it was as though all of the U.S. but Nebraska had sunk into the sea. The two-tier market really consisted of one tier and a lot of rubble down below. What held the Nifty Fifty up? The same thing that held up tulip-bulb prices long ago in Holland - popular delusions and the madness of crowds. The delusion was that these companies were so good that it didn't matter what you paid for them; their inexorable growth would bail you out.” Forbes Magazine during the 50% market collapse of 1973-74

Last week, the price of Greek government debt soared on hopes of an 11th hour stick-save bailout by the European Union. Unfortunately, that price jump still left Greek bonds priced to reflect a default probability of 100% at every maturity. The jump only reflected an increase in the amount that bondholders evidently expect to recover in default, raising the implied recovery rate from the recent low near 30% to something closer to 50%. Put another way, the bond market has fully priced in the likelihood of a default coupled with a major haircut on Greek debt.

With valuations still extreme and deterioration in market action continuing to indicate a shift toward risk-aversion among investors, we are less concerned about specific factors such as Greece than about much more general pressures that threaten to force an upward spike in compressed risk-premiums. We’ve often noted that a market collapse is nothing other than that phenomenon: razor-thin risk premiums that are then pressed abruptly to higher levels.