Let’s begin with a reminder of where we are in the market cycle. At present, the stock market is in a mature, heavily bullish, overbought, overvalued bull market advance, near a multi-year high in the S&P 500, with consumer confidence at similar multi-year highs, with the broad perception that downside risk is insignificant, and that “tail risk” has been eliminated. This is a dangerous place to be, because it is precisely where risk aversion is scarce and hated most by investors, and where risk aversion is most likely to be rewarded in the future.
Consider the opposite. Recall the points in time where the stock market has been in a mature, heavily bearish, oversold, undervalued (or at least moderately valued) bear market decline, near a multi-year low in the S&P 500, with consumer confidence at similar multi-year lows, with the broad perception that downside risk is enormous, and that “tail risk” is growing. This is a wonderful place to be, because it is precisely where the willingness to accept risk is scarce and hated most by investors, and where the willingness to accept risk is most likely to be rewarded in the future.
Which market environment is the one where investors should generally be optimistic about multi-year market prospects? Clearly, the second. It’s a description that applies well to the 1974, 1982, 2002 and 2009 bear market lows. In contrast, the present description applies equally well to the 1972, 1987, 2000 and 2007 bull market peaks. It should be utterly obvious here that risk aversion is appropriate in present conditions.
2009 versus 2013
I’ve created some noise in the signal that investors are getting here. That’s because despite obvious historical evidence that we are in very dangerous conditions, it seems quite easy to dismiss these concerns. Why? Two reasons: 1) I insisted on stress-testing against Depression-era data in 2009-early 2010, and missed significant gains in the interim; 2) I missed the opportunity to be more bullish at several points since 2010 where speculation would have been possible (as more recent research suggests that we can “override” negative return/risk estimates even in overvalued markets, provided that trend-following measures are favorable andhostile “overvalued, overbought, overbullish” syndromes are absent).
I frequently discuss our 2009-early 2010 miss, not because I enjoy doing so, but because it remains a source of misunderstanding. If one doesn’t correctly understand why I was defensive then, it's tempting to argue that there's no reason to be defensive now either. At the beginning of the 2003 bull market, I shifted decisively to a constructive view, yet I remained defensive in 2009, despite better valuations. The best way to understand this narrative, and to see why we expect to be appropriately constructive in future cycles, is to understand why we missed that opportunity in the present one.
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Consider the opposite. Recall the points in time where the stock market has been in a mature, heavily bearish, oversold, undervalued (or at least moderately valued) bear market decline, near a multi-year low in the S&P 500, with consumer confidence at similar multi-year lows, with the broad perception that downside risk is enormous, and that “tail risk” is growing. This is a wonderful place to be, because it is precisely where the willingness to accept risk is scarce and hated most by investors, and where the willingness to accept risk is most likely to be rewarded in the future.
Which market environment is the one where investors should generally be optimistic about multi-year market prospects? Clearly, the second. It’s a description that applies well to the 1974, 1982, 2002 and 2009 bear market lows. In contrast, the present description applies equally well to the 1972, 1987, 2000 and 2007 bull market peaks. It should be utterly obvious here that risk aversion is appropriate in present conditions.
2009 versus 2013
I’ve created some noise in the signal that investors are getting here. That’s because despite obvious historical evidence that we are in very dangerous conditions, it seems quite easy to dismiss these concerns. Why? Two reasons: 1) I insisted on stress-testing against Depression-era data in 2009-early 2010, and missed significant gains in the interim; 2) I missed the opportunity to be more bullish at several points since 2010 where speculation would have been possible (as more recent research suggests that we can “override” negative return/risk estimates even in overvalued markets, provided that trend-following measures are favorable andhostile “overvalued, overbought, overbullish” syndromes are absent).
I frequently discuss our 2009-early 2010 miss, not because I enjoy doing so, but because it remains a source of misunderstanding. If one doesn’t correctly understand why I was defensive then, it's tempting to argue that there's no reason to be defensive now either. At the beginning of the 2003 bull market, I shifted decisively to a constructive view, yet I remained defensive in 2009, despite better valuations. The best way to understand this narrative, and to see why we expect to be appropriately constructive in future cycles, is to understand why we missed that opportunity in the present one.
Read the complete commentary
