Over the years, I’ve observed that overvalued, overbought, overbullish market conditions have historically been accompanied by what I call “unpleasant skew” – a succession of small but persistent marginal new highs, followed by a vertical collapse in which weeks or months of gains are wiped out in a handful of sessions. Provided that investors are in a risk-seeking mood (which we infer from the behavior of market internals), sufficiently aggressive monetary easing can delay this tendency, by starving investors of every source of safe return, and actively encouraging further yield-seeking speculation even when valuations are obscene. Once investors become risk averse, as deteriorating market internals have suggested in recent months, vertical declines much more extreme than last week's loss are quite ordinary.
The way to understand the bubbles and collapses of the past 15 years, and those throughout history, is to learn the right lesson. That lesson is not that overvaluation can be ignored indefinitely – we know differently from the collapses that have regularly followed extreme valuations. The lesson is not that easy monetary policy reliably supports stock prices – persistent and aggressive easing did nothing to keep stocks from losing more than half their value in 2000-2002 and 2007-2009. Rather, the key lesson to draw from recent market cycles, and those across a century of history, is this:
Valuations are the main driver of long-term returns, but the main driver of market returns over shorter horizons is the attitude of investors toward risk, and the most reliable way to measure this is through the uniformity or divergence of market internals. When market internals are uniformly favorable, overvaluation has little effect, and monetary easing can encourage further risk-seeking speculation. Conversely, when deterioration in market internals signals a shift toward risk aversion among investors, monetary easing has little effect, and overvaluation can suddenly matter with a vengeance.
Last week’s decline, while seemingly significant, was actually a rather run-of-the-mill example of “unpleasant skew” that has regularly followed similar market conditions throughout history. I’ve updated the chart I presented last week, which shows how contained last week’s market loss actually was in the context of present conditions. As I wrote a week ago, “It's the 8% of history that matches current conditions where most market crashes have occurred. The chart below shows the cumulative total return of the S&P 500 restricted to this subset of history. The chart is on log scale, so each horizontal line represents a 50% loss. The vertical lines straight down are actually 2-3 week air pockets, free-falls and crashes where stocks experienced losses of as much as 25%, often with continued (but less predictable) follow-on losses after exiting this particular return/risk profile. The past several months appear as a little congestion area in the lower right of the graph. Investors should emphatically not rule out progressive losses – even a straight line down – under present conditions.”
The 8% subset of history matching present conditions captures a cumulative loss in the S&P 500 equivalent to turning a dollar into less than 7 cents. Conversely, the remaining 92% of market history captures a cumulative gain in the S&P 500 of more than (1/.07=) 14 times the overall return in the index across history. You’ll note that I’ve added an additional segment below 0.0625 as a reminder that each horizontal bar lower represents a further 50% market loss. We’re probably going to need that extra room.
The good news is that we’re not going to stay in this 8% subset of historical conditions indefinitely, and the current market return/risk profile is the only one where severe market losses should be strongly expected. Another 32% of return/risk conditions we identify are associated with relatively flat expected market returns (generally near or below Treasury bill yields, on average, but including both positive and negative fluctuations). In those conditions, significant market risk isn’t worth taking because the weak average returns still come with the potential for sizeable interim losses. That sort of condition encourages a neutral investment stance, or one that is “constructive with a safety net.” The remaining 60% of market conditions we identify are associated with strongly positive expected return/risk profiles, where an unhedged or aggressive outlook is reasonable. Our shift to that outlook will likely occur at the point when a material retreat in valuations is joined by an improvement in market internals.
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