The problem with speculation is that there’s usually a gap between the underlying risk and the inevitable outcome. The gap is most dangerous when there are potential rewards for pushing your luck. (View Highlight)
Valuations and market internals continue to be essential in navigating the complete market cycle. Our most reliable valuation measures remain well-correlated with subsequent long-term returns and full-cycle drawdowns. Indeed, while the average level of valuations has been above historical norms in recent decades, the average level of subsequent returns has predictably been lower than historical norms. It has taken the most extreme yield-seeking bubble in history to bring the total return of the S&P 500 to even 6.27% since its March 2000 peak, much of which I suspect will be wiped out in the next few years. Likewise, the entire total return of the S&P 500 in the most recent market cycle accrued in periods when market internals were favorable. (View Highlight)
Still, it’s impossible for us to examine current valuation extremes without also allowing for the S&P 500 to lose more than half of its value – even from here. That’s not so much a forecast as a “full cycle” estimate of the market loss that would be required to restore historically run-of-the-mill expected returns. It’s also worth noting that when Treasury bill yields have stood between 3-5%, as they do today, our most reliable valuation measures have stood at just half of their present levels, on average. (View Highlight)
A few charts will help to illustrate our concerns about current market conditions. Below is our single most reliable valuation measure: the market capitalization of nonfinancial corporations as a ratio to gross value-added, including estimated foreign revenues. We gauge the reliability of our valuation measures based on their correlation with actual subsequent market returns across history. Other reliable measures (for example, Market Cap/GDP, S&P 500 price/revenue, and our Margin-Adjusted P/E) look quite similar. The advance to the January 2022 market peak took valuations beyond the extremes of 2000 and even 1929. Last year’s market decline merely skimmed the most speculative froth, bringing valuations to the same extreme we observed at the March 2000 bubble peak. (View Highlight)
In 1998, I introduced our gauge of market internals – what I called “trend uniformity” at the time. It continues to be an essential element of our investment discipline. The specific signal extraction approach is one of the few things I keep proprietary, but I’m very open about the central concept. When investors are inclined to speculate, they tend to be indiscriminate about it, so the “uniformity” of market internals across thousands of stocks, industries, sectors, and security-types conveys information about that psychology. (View Highlight)
The flat portions in the chart below are periods when, like last year, market internals were persistently unfavorable, leading us to prefer T-bills or hedged equity to unhedged market risk. You’ll see the same tendency during the 2000-2002 and 2007-2009 collapses. We can’t rule out “whipsaws,” and we don’t expect internals to “catch” short-term market fluctuations. Still, in the nearly 25 years since I introduced our measure of market internals, I haven’t found a more useful way to gauge speculation versus risk- (View Highlight)
I’ll say this again. Value is not measured by how far prices have declined, but by the relationship between prices and properly discounted cash flows. We presently estimate that the S&P 500 would have to drop to the 2800 level simply to establish prospective 10-year returns equal to those of 10-year Treasury bonds. Restoring a historically run-of-the-mill 5% expected return over-and-above Treasury bond yields would require a decline to the 1850 level. Restoring historically run-of-the-mill 10% expected long-term returns for the S&P 500 would require, by our estimates, a decline to the 1600 level. (View Highlight)
When you hear Wall Street analysts talking about the attractiveness of stocks versus bonds, it’s imperative to ask whether the model they’re using actually has any meaningful relationship to subsequent returns. It’s one of my great frustrations with this industry that the answer is typically “no.” (View Highlight)
Unfortunately, we presently estimate that S&P 500 total returns are likely to lag the returns of Treasury bonds by -3.4% annually over the coming decade. Given that the 10-year Treasury bond yield is currently about 3.4%, that also implies that we estimate S&P 500 total returns to average about zero over the coming decade. (View Highlight)
The red shading shows the deepest actual subsequent S&P 500 loss over the following 3-year period. Notice that there’s often quite a bit of “white space” between the blue cups and the red ink that eventually fills them. That white space represents high risk with no apparent consequence; periods that enticed speculators to run across minefields and to push their luck. (View Highlight)
Despite the profound risks that we believe are baked into the cake of valuations, I’ll say this again – at any point when our measures of internals suggest that investor psychology has shifted toward speculation, we’ll refrain from adopting or amplifying a bearish market outlook. Indeed, even at current valuations, a shift to uniformly favorable internals would encourage us to adopt a constructive market outlook more often than not (albeit with position limits and safety nets). We understand the valuation risks, but we also understand that there are certain periods when investors could not care less about valuation risks. Our job is to adhere to a value-conscious, historically-informed, risk-managed, full-cycle investment discipline, and we’ve adapted in ways that enable us to respond flexibly to market conditions as they change, without the risk of being “pinned” into any given market outlook. (View Highlight)
It seems extremely optimistic for investors to expect smooth sailing, at valuations that still rival the 1929 and 2000 extremes, yet without the reckless zero-interest rate policies that enabled valuations to exceed 1929 and 2000 extremes in the first place. Still, as always, we’ll respond to market conditions as they change over time, and no forecasts are required. (View Highlight)
My view on recession risk remains that employment hasn’t deteriorated to the extent that would be consistent with NBER recession criteria. Despite weakness in various measures of purchasing manager sentiment and credit stress, the employment components of our own Recession Warning Composites have also not yet shifted in a way that suggests an imminent recession. (View Highlight)
As for inflation, my impression is that investors have gotten far ahead of themselves by extrapolating modest improvement in the data. It may be that inflation improves progressively from here, but the problem is that investors have taken it for granted and embedded it into prices, which means that they now rely on that improvement. Any stall in progress on the inflation front, and particularly any upward surprise in core inflation even on the order of 0.2-0.4%, could be strikingly disruptive to both bonds and stocks. (View Highlight)
Now, there are certainly useful perspectives on inflation – my own framework is to examine four drivers – the quantity of government liabilities (measurable), the demand for and confidence in government liabilities (psychological), the supply of goods and services along with slack capacity (measurable), and the demand for goods and services (psychological). As with the stock market, the psychological elements have a self-reflexive impact. Prices affect expectations, which affect prices. The upshot here is that the best predictor of inflation is, well, inflation, and lagged inflation. The next best correlates, but weaker, are negative economic shocks, and shocks to capacity and supply amid unsustainable government deficits. (View Highlight)
So unless we get smacked by recession and credit strains, which aren’t really evident here, my impression is that inflation may be more persistent than investors seem to be banking on. That’s where investors are really getting themselves into danger. Based on historical relationships between interest rates, core inflation, nominal GDP growth, unemployment, and other factors, the lower bound for a “Fed pivot” and the typical lower bound for the 10-year Treasury bond yield are both in the area of 5.2% here. By pricing bonds and other assets in a way that assumes that inflation will come down rapidly and in a straight line, investors have put themselves in the position of relying on inflation to come down rapidly and in a straight line. (View Highlight)
The bottom line is simple. We don’t require forecasts, but investors should not ignore risks or insist on pushing their luck. The present combination of extreme valuations and unfavorable market action creates a “trap door” of downside risk for the financial markets. Likewise, the persistence of extreme valuations – in the absence of the causes and conditions that encouraged those extreme valuations – creates risk. The tendency of negative estimated risk-premiums to resolve into deep market drawdowns over the next 30-36 months creates risk. The reliance of investors on “forward earnings” multiples that embed record profit margins creates risk. The assumption that inflation will come down in a rapid and linear fashion, despite historical persistence of inflation, creates risk. (View Highlight)