Present market conditions join the second most extreme valuations in U.S. history (on measures most reliably correlated with actual subsequent 10-year S&P 500 total returns) with increasing divergences and dispersion in market internals. Despite current extremes, valuations say very little about near term market direction. Valuations are enormously informative about likely market returns over horizons of 7-15 years. In contrast, market internals convey a great deal of information about the prevailing risk preferences of investors, and that's what amplifies our concerns here. Uniformly favorable internals across a wide variety of sectors and security types typically convey a signal that investors have a robust willingness to seek and accept risk, and it’s that feature that can allow overvalued markets to become persistently more overvalued. But remove that feature, and overvalued markets have often become vulnerable to vertical air pockets, panics, and crashes.
I’ll say this again – valuations alone are not the concern. It’s the additional feature of deteriorating market internals that introduces a critical element of risk here. That feature helped us to correctly warn of the 2000-2002 and 2007-2009 collapses, and shift to a constructive outlook in-between. The recent half-cycle since 2009 has been more challenging as the inadvertent result of my 2009 insistence on stress-testing our methods of classifying market return/risk profiles against Depression-era data. The resulting ensemble methods outperformed every approach we had ever tested against post-war data, Depression-era data, and holdout validation data, but they also encouraged an immediate defensive stance when overvalued, overbought, overbullish syndromes emerged. Throughout history, those syndromes had regularly been accompanied or closely followed by breakdowns in market internals. The one truly “different” aspect of the half-cycle since 2009 is that quantitative easing disrupted that regularity. Nearly a year ago, weimposed overlays on our methods that require hard-defensive investment stances to be accompanieddirectly by deterioration in market internals or other risk-sensitive measures (e.g. credit spreads).
It’s worth emphasizing that until mid-2014, the strongly defensive outlook we took in recent years would have been rejected by those overlays more than two-thirds of the time. Without those bubble-tolerant overlays, our actual experience was largely a mirror image (though muted) of the escalating valuation extremes. As I observed then, we don't get to re-live the recent cycle in a way that demonstrates the effectiveness of those adaptations, but we can certainly do so over time. On that front, market conditions presently (and in recent quarters) support a hard-defensive outlook that's largely identical to those we took in 2000 and 2007. The same return/risk profile has been associated with vertical market losses in market cycles across history. The chart below shows the cumulative total return of the S&P 500, restricted to the 8% of historical periods with an estimated return/risk profile matching what we presently observe. The overall returns are also partitioned between periods of Fed easing and Fed tightening. The notion that Federal Reserve easing prevents market losses is simply historically uninformed. Even a cursory review of the last two market collapses should suffice as a reminder.
What creates a temptation to ignore risk here is that the S&P 500 has recently advanced despite these conditions. Recognize that this has also periodically occurred in prior instances, but the average outcome is still substantially negative. In contrast, the broad market (see for example the NYSE Composite) has been in a sideways distribution pattern for nearly a year. The chart below compares recent action in the NYSE Composite to the period surrounding the 2000 peak. Narrowing broad market participation coupled with recent highs in the S&P 500 and Nasdaq does create a short-term challenge for hedged equity strategies – which are typically diversified across broad range of equities and hedged with large-cap indices – but we certainly don’t view that as a reason to reduce defenses here. That said, an improvement in market internals and credit spreads would reduce the urgency of our downside concerns.
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