Headed for the Tail
Headed for the Tail

Headed for the Tail

At present, we estimate that a market loss of about -30% would be required to restore expected 10-year S&P 500 total returns to the same level as 10-year Treasury bond yields; about -55% to bring the expected total return of the S&P 500 to a historically run-of-the-mill 5% premium over-and-above Treasury yields; about -60% to bring the estimated 10-year total return of the S&P 500 to a historically run-of-the-mill level of 10% annually. (View Highlight)

I intentionally use the phrase “run-of-the-mill” to describe potential market losses of -30%, -55%, and -60%, because none of these estimates can be considered “worst case scenarios.” Historically, market cycles typically trough at the point where prospective S&P 500 total returns are restored to the greater of a 10% nominal return or 2% above Treasury bonds, so I lean toward expecting the -60% outcome. Nothing in our discipline relies on that outcome. Still, I believe it is not only possible but likely. (View Highlight)

Speculative market cycles often involve extended segments with extreme valuations that then become more extreme without apparent consequence. Those segments of the market cycle are what market internals are for – we’ll talk about that shortly. Still, the deferral of consequences is very different from the absence of consequences. My concern is for investors that may discover that the hard way. (View Highlight)

It’s essential to emphasize, right at the outset, that nothing in our discipline relies on valuations to retreat anywhere near their historical norms. I clearly expect that they will, but we emphatically don’t rely on that. Our discipline is to align our investment outlook with measurable, observable market conditions, particularly valuations and market internals. With one important exception, that’s the same discipline that allowed us to navigate decades of previous market cycles, including the tech and mortgage bubbles and their subsequent collapses (not everyone recalls that I was a leveraged, “lonely raging bull” in the early 1990’s). (View Highlight)

The trap door opens when rich valuations are joined by risk-aversion. We find that speculative and risk-averse psychology is best gauged by the uniformity or divergence of market internals over thousands of individual stocks, industries, sectors, and security types, including debt securities of varying creditworthiness. When investors are inclined to speculate, they tend to be indiscriminate about it. In contrast, deterioration and divergence of market internals is the hallmark of emerging risk-aversion. (View Highlight)

Although some shifts in market internals are short-lived “whipsaws” and some shifts persist for well over a year, it’s typical for market internals to shift about twice a year. We don’t use internals in an attempt to “time” or “catch” short-term market fluctuations. Rather, internals are best used as a gauge of speculative versus risk-averse investor behavior, and we respond to shifts in combination with valuations, as well as other useful though less essential considerations. (View Highlight)

That should be increasingly evident since 2019. So even as we examine the risk of a -60% market collapse below, keep in mind that valuations are only part of our investment discipline. If investors shift back to speculative psychology, market internals will be among the elements that preserve our flexibility, even in the unlikely event that valuations remain elevated indefinitely. (View Highlight)

The 2022 decline did nothing but remove the most extreme froth from valuations, leaving the price/sales multiple of the S&P 500 above the level it reached at the 2000 bubble peak, and at the same level observed at market peaks in 2018 and 2020. To expect an extended market advance from here is essentially to view the area in the red box as the “new normal,” and to dispense with all of market history before late-2020. (View Highlight)

While we find measures like MarketCap/GVA, MAPE, and even price/revenue to be more reliable than earnings-based measures, the main consideration for any valuation ratio is to choose a denominator that is representative and proportional to very, very long-term cash flows. Even the Shiller Cyclically-Adjusted P/E (CAPE) does a serviceable job in this regard. (View Highlight)

On this point, it turns out that the price/forward earnings multiple and the Shiller CAPE (which has a far longer history) are well correlated. Based on the estimated relationship between the two, it’s easy to see that a historically “normal” level for the S&P 500 price/forward operating earnings multiple is only about 11. (View Highlight)

The chart below shows our estimate of likely 12-year average annual total returns for a passive investment portfolio allocated 60% to the S&P 500, 30% to Treasury bonds, and 10% to Treasury bills. Presently, this estimate is less than 1% annually. Needless to say, we prefer a value-conscious, hedged-equity discipline. (View Highlight)

Among the most repeated phrases on Wall Street during the past decade is the assertion that “low interest rates justify high valuations.” The problem with this phrase is that it is treated as a “hall pass” to justify mindless speculation – ignoring any consideration about the extent of those high valuations, or the consequences of those high valuations. (View Highlight)

Now, it’s true that for any set of future cash flows, the higher the price investors pay, the lower the returns they can expect. If interest rates are low, and the future cash flows are unchanged, then it makes sense to price stocks for lower future returns as well (View Highlight)

While there’s certainly not a one-to-one correspondence between interest rates and market valuations, low interest rates do tend to accompany rich stock market valuations. But those rich stock market valuations, in turn, are also associated with low or dismal subsequent market returns. Again, the function of the “high valuations” is to drive future stock returns to levels commensurate with the low interest rates. (View Highlight)

Put simply, low interest rates may be the “friends” of investors in the rear-view mirror, because they tend to encourage an advance to rich market valuations. But those rich valuations also have consequences. Moreover, notice that there is a section of the plot where subsequent market returns were below zero. (View Highlight)

On the subject of risk aversion, it will be increasingly important to monitor low grade credit in the months ahead. As noted earlier, the impact of higher interest rates tends to hit corporations with a lag of about a year or more, as existing debt comes up for refinancing. We already observe emerging economic strains, and though we would require more weakness in the employment figures before projecting an economic recession with high confidence, employment figures tend to lag other economic data. (View Highlight)

My impression is that the U.S. economy will be in recession by mid-year. Given the conditions already in place, even a modest increase in the rate of unemployment to about 3.8% would be sufficient to trigger our Recession Warning Composite. While stock market weakness often precedes recessions, the lead time is typically only a few months. (View Highlight)

Don’t blame the Fed for a market collapse, a recession, a pension crisis, or corporate credit strains – all which I suspect are already baked in the cake. Instead, blame a decade of unrestrained monetary policy that encouraged yield-seeking speculation and enormous issuance of low-grade debt and equity securities. The only differences between the recent bubble and the mortgage bubble are that this bubble was far more aggressive and extended, and it affected a much broader range of securities. (View Highlight)

For example, the rich valuations of early 1972 correctly anticipated below-average S&P 500 total returns even though growth in nominal GDP and corporate revenues was quite strong over the following decade. That’s because valuations at the end of that 10-year horizon ended at depressed levels, due to high interest rates in 1982 (View Highlight)