We continue to classify the prospective equity market return/risk profile within the most negative climate we identify.
The basis of this classification is fairly straightforward. Historically, once an extended speculative period of extreme overvalued, overbought, overbullish conditions gives way to increasing risk aversion, as indicated by deterioration in market internals (and particularly in the presence of hostile yield trends in the form of widening credit spreads), the stock market has become vulnerable to vertical losses.
Though not every instance of this syndrome has been followed by a market collapse, every notable panic and market crash across more than a century of data has featured that basic setup.
Valuations remain extreme on the basis of measures most tightly correlated with subsequent 10- to 12-year Standard & Poor's 500 total returns in market cycles across history (see Rarefied Air: Valuations and Subsequent Market Returns). When investors are inclined toward speculation, as evidenced by indiscriminately uniform market action across risk assets, even obscene overvaluation can be followed by further risk seeking (see The Hinge).
At present, however, market internals have deteriorated substantially, including spiking credit spreads in the debt markets. Beyond those factors, we also observe evidence of an oncoming global economic downturn, including a U.S. recession (see A Growing Risk of Recession and An Imminent Likelihood of Recession).
In the absence of a clear resumption of risk-seeking across the global economy, further monetary easing is likely to be ineffective in reversing current strains. As investors should recall from the 2000-2002 and 2007-2009 plunges, both which were attended by continuous and aggressive monetary easing, monetary easing in itself is not typically enough to provoke resumed risk seeking (see When An Easy Fed Doesn’t Help Stocks and When it Does and The Gas Pedal is Useless When the Spark Plugs Are Gone).
Warning with a capital 'W'
Given our focus on historically informed, value-conscious, full-cycle investing, I generally don’t place much attention on short-term technical factors or specific patterns of price action. However, the current setup is one of the few exceptions. In a market return/risk classification that is already the most negative we identify, where a sustained period of speculation has given way to increasing risk aversion, the position of the market relative to very widely identified “support” (about the 1820 level on the S&P 500) is of particular note.
Often, well-recognized support levels become places where dip buyers and swing traders line up on the buy side, on the assumption that they’ll be rewarded if the market bounces from that support and that they can quickly cut their losses if the support level is broken. The problem here is that, when too many speculators set their stop-loss levels at the same level, and valuations are still elevated, there may be neither speculators nor value-conscious investors willing to bid for stock anywhere near those support levels once they break. The resulting gap between eager sellers at a high level and willing buyers at a much lower level is the essential element of market crashes, because every seller requires a buyer.
I’ve often observed that market crashes have historically emerged only after a familiar profile of market behavior that features a compressed market retreat of about 14% over 10 to 12 weeks, a rebound between one-third and two-thirds of that decline, a fresh retreat that slightly breaks that initial level of support, a one-day reflex rebound, and then a collapse as that support level is broken. In the 1990s, I called this pattern “Five Days of Armageddon” because historically, once rich valuations have been joined with poor market internals (what I used to call “trend uniformity”), the break of a widely identified support level has often been followed by vertical market losses.
Continue here.
