The Federal Reserves policy of quantitative easing has produced a historically prolonged period of speculative yield-seeking by investors starved for safe return. The problem with simply concluding that quantitative easing can do this forever is that even speculative assets have to compete with zero. When a safe zero return is above the medium or long-term return that one can estimate for a very risky asset, the rationale for continuing to hold the risky asset becomes purely dependent on expectations of immediate short-term price gains.

Market extremes generally share a common formula. One part reality is blended with one part misguided perception (typically extrapolating recent trends as if they are driven by some reliable and permanent mechanism), and often one part pure delusion (typically in the form of a colorful hallucination with elves, gnomes and dancing mushrooms all singing in harmony that reliable valuation measures no longer matter).

Market conditions presently match those that have repeatedly preceded either market crashes or extended losses approaching 50% or more. Such losses have not always occurred immediately, but they have typically been significant enough to wipe out years of prior market gains. Our present views are not built on the forecast that stocks must decline immediately, or that we wont go through some additional discomfort if the market pushes to a higher peak. Still, a century of history strongly warns that whatever transitory gains the market achieves from present levels will be wiped out in spad

Market peaks are a process, not an event or an instant. Investors should be thinking very seriously about the extent of potential market losses over the completion of the present market cycle. It is the wrong question to ask where else am I going to put my money with short-term interest rates near zero? The problem with that question is that it carries the implicit assumption that the expected return on stocks is even positive or adequate given the prospective risks.

Overly compressed risk premiums are now the largest ticking time bomb in the global financial environment.

Investors have again pushed the stone to the top of the mountain.

If you think the market is not going to lose a large fraction of its value over the next few years, a century of history thinks youre wrong.

Taking the broad stock market as a whole, and considering all stocks ? not simply the largest of the large caps ? investors are now making the broadest and most leveraged bet on overvalued equities in U.S. history. Conditions somehow do not feel so dangerous because profit margins are cyclically extreme, but I suspect that this only means that investors will be surprised by the depth of the markets losses, as they were in 2000-2002 and 2007-2009. The lessons on this really are freely available all the way back to the South Sea Bubble.

The Federal Reserve has stomped on the gas pedal for years, inadvertently taking price/earnings ratios at face value, while attending to ?equity risk premium? models that have a demonstrably poor relationship with subsequent market returns. As a result, the Fed has produced what is now the most generalized equity valuation bubble that investors are likely to observe in their lifetimes.

In viewing the Fed?s mandate as a tradeoff only between inflation and unemployment, Chair Yellen seems to overlook the feature of economic dynamics that has been most punishing for the U.S. economy over the past decade. That feature is repeated malinvestment, yield-seeking speculation, and ultimately financial instability, largely enabled by the Federal Reserve?s own actions.

The Iron Law of Valuation is that every security is a claim on an expected stream of future cash flows, and given that expected stream of future cash flows, the current price of the security moves opposite to the expected future return on that security. A corollary to the Iron Law of Valuation is that one can only reliably use a ?price/X? multiple to value stocks if ?X? is a sufficient statistic for the very long-term stream of cash flows that stocks are likely to deliver into the hands of investors for decades to come.

Having witnessed the glorious advancing portion of the uncompleted market cycle since 2009, investors might, perhaps, want to consider how this cycle might end. After long diagonal advances to overvalued speculative peaks, the other side of the mountain is typically not a permanently high plateau.

The Fed is wisely and palpably moving away from the idea that more QE is automatically better for the economy, and has started to correctly question the effectiveness of QE, as well as its potential to worsen economic risks rather than remove them.

Fed-induced speculation does not create wealth. It only changes the profile of returns over time. It redistributes wealth away from investors who are enticed to buy at rich valuations and hold the bag, and redistributes wealth toward the handful of investors both fortunate and wise enough to sell at rich valuations and wait for better opportunities.

The so-called ?dual mandate? of the Federal Reserve does not ask the Fed to manage short-run or even cyclical fluctuations in the economy. Instead ? whether one believes that the goals of that mandate are achievable or not ? it asks the Fed to ?maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.?

Regardless of very short-term market direction, it is urgent for investors to understand where the equity markets are positioned in the context of the full market cycle.

Foreign profits as a share of GNP have been contracting since 2007, are only about two-tenths of a percent above the 2009 low, and therefore do not have any material role in the surge in overall profit margins we?ve observed in recent years. The surge can be fully explained by mirror image deficits in household and government saving - a relationship that can be demonstrated across decades of historical evidence.

We would dismiss classic topping patterns we observe here if the recent market peak did not feature the "full catastrophe" of textbook speculative features, particularly the same syndrome of extreme overvalued, overbought, overbullish, rising yield conditions observed (prior to the past year) only at major market peaks in 2007, 2000, 1987, 1972, and 1929. Meanwhile, we remain encouraged. Those who follow a historically informed, value-conscious, and risk-managed investment discipline should be among the most optimistic investors in the financial markets.

On the basis of a broad range of valuation measures that are tightly (nearly 90%) correlated with actual subsequent S&P 500 total returns over the following decade, we estimate that stock prices are about double the level that would generate historically adequate long-term returns.

Speculators have been luckier than they may realize, and are now pushing their luck. Quantitative easing has distorted not only financial markets, but financial memory. The awakening is not likely to be gentle.

The potential collapse of a now-complete log-periodic bubble is best considered something of a physics experiment, and its not what drives our investment stance. Still, the backdrop of steep overvaluation, extreme bullish sentiment, record margin debt, and international dislocations could hardly provide a more fitting context for a disruptive completion to the present market cycle.

When you believe in things that you dont understand, then you suffer.

In my view, the stock market is hovering in what has a good chance of being seen in hindsight as the complacent lull before a period of steep losses. Meanwhile, we would require a certain amount of deterioration in stock prices, credit spreads, and employment growth to amplify our economic concerns, but even here we can say that there is little evidence of economic acceleration. Broad economic activity continues to hover at levels that have historically delineated the border of expansions and recessions.

Its the very nature of a peak that it cant be produced except by unusual optimism.

A defensive outlook here does not presume, require, or rely on a market crash. Our ongoing discipline is to align our investment outlook with the market return/risk profile that we estimate on the basis of a broad ensemble of evidence that we can test historically and validate in out-of-sample data. That outlook will shift as that evidence shifts, period.

We feel no particular obligation defend the CAPE ratio. It has a strong long-term relationship to subsequent 10-year market returns. And its only one of numerous valuation indicators that we use in our work - many which are considerably more reliable.

The bell has already rung. The diva is already singing. The only question is precisely how long they hold the note.

The problem is not simply that earnings are likely to retreat deeply over the next few years. Rather, the problem is that investors have embedded the assumption of permanently elevated profit margins into stock prices, leaving the market about 80-100% above levels that would provide investors with historically adequate long-term returns. An equivalent way to say this is that stocks are currently at levels that we estimate will provide roughly zero nominal total returns over the next 7-10 years, with historically adequate long-term returns thereafter.

The stock market is presently at valuations where not only cyclical but secular bear markets have started. A secular bear period comprises a series of cyclical bull-bear periods where valuations gradually work their way lower at each successive cyclical trough. The past 13 years of paltry overall total returns for the S&P 500 have unfortunately corrected very little of the excess in 2000, largely thanks to yet another round of Fed-enabled speculation. We should have learned how these episodes end.

Investors will do themselves terrible harm if they ignore the objective warnings of history based on our subjective experience in this unfinished half-cycle. That subjective experience is far more closely related to my 2009 stress-testing decision than many investors recognize.

The Fed has done enough, and perhaps dangerously more than enough. The prospect of dismal investment returns in equities is an outcome that is largely baked-in-the-cake. The only question is how much worse the outcomes will be as a result of Fed policy that has few economic mechanisms other than to encourage speculative behavior.

At bull market peaks, it often seems that the market is simply headed higher with no end in sight, and buy-and-hold appears superior to every alternative. Meanwhile, the reputation of value-conscious investors and risk-managers goes from champ to chump. Then, the bamboo tree suddenly sprouts, and the entire lag is often replaced by outperformance in less than a year. Only after the fact does the reputation of risk-managed strategies surge from chump to champ.

Despite the unusually extended period of speculation as a result of faith in quantitative easing, I continue to believe that normal historical regularities will exert themselves with a vengeance over the completion of this market cycle. Importantly, the market has now re-established the most hostile overvalued, overbought, overbullish syndrome we identify.

Its fascinating to hear central bankers talk about the economy, because in the span of a few seconds they can say so many things that simply arent supported by the evidence. For anyone planning to watch the confirmation hearings for the next Fed Chair, the evidence below is provided as something of a leash to restrain the attacking dogma.

One thing that separates humans from animals is the ability to evaluate whether there is really any actual mechanistic link between cause and effect. When we stop looking for those links, and believe that one thing causes another because it just does we give up the benefits of human intelligence and exchange them for the reflexive impulses of lemmings, sheep, and pigeons.

Much of the present faith in monetary policy derives from the belief that it was the central factor in ending the banking crisis during what is often called the Great Recession. On careful analysis, however, the clearest and most immediate event that ended the banking crisis was not monetary policy, but the abandonment of mark-to-market accounting by the Financial Accounting Standards Board on March 16, 2009, in response to Congressional pressure by the House Committee on Financial Services on March 12, 2009.

On all evidence, were far more inclined to view the position of stock prices as a temporary overextension of already extreme conditions than some durable change in the workings of the financial markets.

Investors and analysts fall over themselves daily to analyze and interpret the latest data from regional Fed surveys (e.g. Philly Fed, Empire Manufacturing), purchasing managers indices (e.g. national manufacturing, national services, regional PMIs), and other economic measures (e.g. new unemployment claims, average weekly hours). The problem is that virtually all of these measures have become not only uncorrelated with subsequent economic outcomes, but negatively correlated with subsequent outcomes.

Stocks are a claim on a very long-term stream of future cash flows that will be distributed to shareholders over time, and P/E ratios are simply a shorthand. P/E ratios are useful only to the extent that the earnings measure being used is reasonably representative and informative about the long-term stream of cash flows what might be called a sufficient statistic.

In my view, the problem with quantitative easing is that its entire effect relies on provoking risk-taking by those who would otherwise choose not to do so; that the FOMC has extended and amplified financial market distortions without regard to the rich valuations and dismal prospective returns that financial assets are most likely priced to achieve; and that this distortion of financial asset prices has precious little to do with the presumptive goal of Fed policy, which is greater job creation and economic activity.

Our view is that the Federal Reserve will taper its program of quantitative easing this week, in the range of a $10-15 billion reduction in the pace of monthly debt purchases. The Fed really has no communication problem about this the economic impact of further quantitative easing has had diminishing returns, and the economic drag from fiscal reductions has thus far been smaller than the Fed feared when it justified QEternity on the basis of those concerns last year.

Even if the S&P 500 Index goes nowhere over the coming decade - as historically reliable measures of valuation suggest - it will probably go nowhere in an interesting and volatile way, providing better value and opportunities that are well-supported by historical evidence. The challenge will be to maintain discipline even when frustration begs investors to abandon it.

Though I expect that the present cycle will be completed by a market loss on the order of 40-55%, conditions can certainly emerge over the course of this cycle that could warrant a more constructive stance than we have presently, though possibly less extended than wed like. The most likely constructive opportunity would emerge from a moderate retreat in market valuations, ideally to oversold conditions from an intermediate-term perspective, coupled with an early firming in measures of market internals.

We presently observe what might best be called a broken speculative peak a strenuously overvalued, overbought, overbullish, rising yield syndrome followed by a breakdown in market internals.

The period of generally rich valuations since the late-1990s (associated with overall market returns hardly better than Treasury bill returns since then) has created a tolerance for valuations that, in fact, have led to awful declines, and have required fresh recoveries to elevated valuations simply to provide meager peak-to-peak returns.

In his classic treatise on speculation, Manias, Panics and Crashes (originally published in 1978), the late Charles Kindleberger laid out a pattern of events that has periodically occurred in financial markets throughout history. Drawing on the work of economist Hyman Minsky, the conditions he described are likely far more relevant at the present moment than investors may recognize.

Once the risk premium is beaten out of stocks, there is no way out, and nothing that can be done about it. Poor subsequent returns, market losses, and the associated destruction of financial security (at least for the bag-holders) are already baked in the cake. This should have been the lesson gleaned from the period since 2000, but because it remains unlearned, it will also become the lesson of the coming decade.

The most important part of every studied investment discipline is the diligence to follow it even at points where it is frustrating to do so.

Ive always thought that singing Rock-a-bye baby offers a bizarre lesson to our young, encouraging them to be lulled gently to sleep by describing a scene that should have them wide-eyed with terror.

Taken together, the financial markets have priced a wide range of assets on the assumption that the U.S. is on the verge of a deflationary boom. Most likely, part of this scenario is wrong.