In recent years, by starving investors of all sources of safe return, the Federal Reserve has successfully engineered an enormous upward shift in the short-run tolerance of investors to accept risk. Unfortunately, there is no reason to believe that human nature has changed as a result, nor is there reason to believe that the long-run, full-cycle tolerance of investors to accept risk has changed. In the short run – the advancing half of the full cycle – the tolerance for financial risk can be effectively rewarded, regardless of valuation, so long as prices are advancing and valuations are becoming progressively more extreme. These episodes typically end when historically identifiablesyndromes of excessive speculation appear (the most extreme version we identify emerged as early as February 2013, and again in May, December, and today). Over the complete market cycle, the tolerance for risk can be rewarded only by the delivery of cash flows that are reasonable in comparison to price paid for the investment, coupled with the absence of significant downward adjustments in valuations over time.
The same speculative pressures that have rewarded short-run risk tolerance in recent years have done so only by removing the potential rewards available for maintaining investment positions and risk-tolerance over the longer-run. The arithmetic is simple – the higher the price one pays for a claim to some stream of future cash flows, the lower the long-run return that an investor will achieve. For a review of current valuations and prospective market returns, see the March 10 comment: It is Informed Optimism to Wait For the Rain.
Fed-induced speculation does not create wealth. It only changes the profile of returns over time. Itredistributes 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. There won’t be many, because rising prices also encourage overconfidence in a permanent ascent. Few investors are capable of enduring the discomfort of being on the sidelines for very long if a speculative market proceeds further without them.
Only those who sell at extreme valuations have the potential to capture any benefit from them, and that benefit only comes by saddling some other investor with poor returns going forward. This is redistribution, not creation of wealth. For those that fail to exit, speculation only changes the profile of returns over time. Excessive reward for short-run risk tolerance goes hand-in-hand with punishment for maintaining that risk tolerance over the longer-run. Over the next few years, the contrast between these short-run rewards and their long-run punishment is likely to be epic. The median stock is more overvalued than at any point in history. Broad market valuations on the most historically reliable measures we identify now exceed the 2007 extreme, and are on parity with 1929. Only the 2000 peak went further.
For the vast multitude of investors, repeated bouts of Fed-induced speculation do nothing but to repeatedly create a false hope and then dash it, as investors should have learned from more than 15 years of alternating speculative episodes and subsequent collapses.
Despite years of excitement during the tech bubble, leading to the 2000 market peak, the completion of the market cycle left the total return of the S&P 500 no greater than the return from Treasury bills for the entire period from May 1996 to October 2002.
Despite years of excitement during the housing bubble, leading to the 2007 peak, the completion of the market cycle left the total return of the S&P 500 no greater than the return from Treasury bills for the entire period from June 1995 to March 2009.
Despite years of Fed-induced hope and speculation that has brought the S&P 500 to its recent heights, we easily expect the completion of the present market cycle to leave the total return of the S&P 500 no greater than the return from Treasury bills for the entire period since early 1998, with annual total returns averaging less than 2% over something like an 18-year span of time. It stands repeating that a run-of-the-mill cyclical bear market in a secular bear market period (which clearly began in 2000 and remains incomplete on the basis of nearly every historically reliable valuation measure) comprises a market loss of about 38%.
