Prevailing market conditions continue to hold the expected stock market return/risk profile in the most negative classification we identify.
That profile reflects not only extreme valuations on the most reliable measures we’ve tested across history, but market internals and other features of market action that remain unfavorable. A sufficient improvement in market internals here would shift the expected market return/risk profile to a more neutral classification. That, coupled with a broader improvement in economic factors, mirroring conditions that prevailed during much of this half-cycle prior to mid-2014, could support an outlook – even at presently obscene valuations – that we might characterize as “constructive with a safety net.” So while our immediate outlook is quite negative, we’ll take new evidence as it comes.
In any event, looking beyond the near-term horizon, I doubt that any shift in market action will meaningfully reduce the likelihood of a 40% to 55% loss in the Standard & Poor's 500 over the completion of the current market cycle, nor the likelihood of 0% to 2% total returns for the S&P 500 on a 10- to 12-year horizon, both of which imply that we fully expect the S&P 500 Index itself to be below present levels 10 to 12 years from today. Put simply, long-term investment outcomes are tightly linked to valuations, but near-term market outcomes are linked to investor attitudes toward risk seeking and risk aversion, which are best inferred from the uniformity of market internals across individual securities, industries, sectors and security types, including debt securities of varying creditworthiness.
That interplay between valuations (which drives long-term investment returns) and market internals (which reflect the shorter-horizon speculative inclinations of investors) was ultimately at the root of our inadvertent difficulties in the half-cycle advance between 2009 and mid-2014. See the “Box” in The Next Big Short for a detailed narrative. Since my mistakes in this half-cycle create the temptation to ignore present risks, I make it a practice to discuss them openly. Skip the next paragraph if you understand those challenges and how we adapted.
As we entered 2009, our investment discipline had admirably navigated preceding complete market cycles, helped us to anticipate the tech collapse and the global financial crisis and encouraged a constructive or aggressive outlook after every bear market decline in my 30 years as a professional investor. While we anticipated the financial crisis, the associated economic collapse was wholly “out of sample” from the standpoint of postwar data, and in 2009 I insisted on stress testing our classification methods against Depression-era data.
The resulting ensemble approach was particularly sensitive to “overvalued, overbought, overbullish” features of market action, which had regularly been followed by poor market outcomes in previous market cycles across history. That regularity became our Achilles' heel in the advancing half-cycle since 2009 because the Fed’s grand experiment in quantitative easing encouraged continued speculation long after historically important warning signals repeatedly emerged. Given this environment, even the most overextended syndromes of market action we identify were not enough; one had to wait until market internals deteriorated explicitly before establishing a hard-negative outlook (an adaptation that we imposed on our classification methods in mid-2014).
While the recent market advance has taken several capitalization-weighted indices within a few percent of their May 2015 highs and has brought the median price-revenue ratio of individual stocks to the highest level in history (eclipsing even the 2000 extreme), trading volume and other measures of sponsorship give recent market action the appearance of a short squeeze rather than a robust shift in the willingness of investors to embrace risk. Moreover, the advance has emerged in the context of a broader retreat in equity markets internationally. This may change, of course, and it’s important to allow for that possibility. But at present, market conditions appear consistent with the late-stage of a major top formation, one that began in mid-2014, has taken the major indices sideways for more than 18 months and broadly peaked in mid-2015. New highs in one index or another, even the S&P 500, would not in themselves be sufficient to shift this profile, but again, we don’t rule out a more uniform shift that would suggest a return toward risk-seeking preferences among investors.
