All of this presents us with a quandary. We can take a defensive outlook based on long-term historical evidence consistently linking overvalued, overbought, overbullish conditions to dismal subsequent market outcomes over the completion of each previous market cycle. Or we can throw history to the wind because these same overvalued, overbought, overbullish conditions have been followed by oddly positive market returns during the advancing portion of the present cycle, particularly since September 2011.
Actually, there’s not a moment of hesitation about which choice we’ll make, but it adds a little suspense to call it a quandary.
Let’s put some data on this. Even with the additional exclusions that we’ve introduced in recent years, since 1940, overvalued, overbought, overbullish conditions sufficient to warrant our strongest defensive outlook have emerged about 5% of the time. I’ve often noted that these hostile conditions have historically been associated with average market losses on the order of 40-50% on an annualized basis. If we examine the performance of the S&P 500 restricted to the periods when these strong overvalued, overbought, overbullish conditions were in place, these periods capture a cumulative 85% loss in the index, including dividends. I’ve plotted this on log-scale to show the consistency of these negative outcomes. You’ll also notice the little “quandary” on the very right side of the chart.
To put the impact of the cumulative loss during these periods into perspective, consider the effect of avoiding this loss. Since 1940, holding Treasury bills during this 5% of history and remaining invested in the S&P 500 the other 95% of the time would have resulted in a cumulative total return close to 7 times greater than a passive buy-and-hold strategy. Notably, while avoiding these periods would have been of dramatic long-term benefit, they aren’t nearly frequent enough to exclude the bulk of most bear market losses, so one still would have suffered a 30% drawdown in the 1970 bear market, and 40% drawdowns in the 1973-74 and 2008-2009 bear markets. Attention to a combination of valuations and market internals would have effectively navigated much of those bear markets, but the chart above may help to understand why strenuously overvalued, overbought, overbullish syndromes have historically outweighed all other considerations, including trend-following and monetary factors.
Read the complete commentary