Unless we observe a rather swift improvement in market internals and a further, material easing in credit spreads – neither would relieve the present overvaluation of the market, but both would defer our immediate concerns about downside risk – the present moment probably represents the best opportunity to reduce exposure to stock market risk that investors are likely to encounter in the coming 8 years.
Last week, the cyclically adjusted P/E of the S&P 500 Index surpassed 27, versus a historical norm of just 15 prior to the late-1990’s market bubble. The S&P 500 price/revenue ratio surpassed 1.8, versus a pre-bubble norm of just 0.8. On a wide range of historically reliable measures (having a nearly 90% correlation with actual subsequent S&P 500 total returns), we estimate current valuations to be fully 118% above levels associated with historically normal subsequent returns in stocks. Advisory bullishness (Investors Intelligence) shot to 59.5%, compared with only 14.1% bears – one of the most lopsided sentiment extremes on record. The S&P 500 registered a record high after an advancing half-cycle since 2009 that is historically long-in-the-tooth and already exceeds the valuation peaks set at every cyclical extreme in history but 2000 on the S&P 500 (across all stocks, current median price/earnings, price/revenue and enterprise value/EBITDA multiples already exceed the 2000 extreme). Equally important, our measures of market internals and credit spreads, despite moderate improvement in recent weeks, continue to suggest a shift toward risk-aversion among investors. An environment of compressed risk premiums coupled with increasing risk-aversion is without question the most hostile set of features one can identify in the historical record.
Short term interest rates remain near zero, 10-year bond yields have declined below 2%, and our estimate of 10-year S&P 500 total returns has declined to just 1.4% (see Ockham’s Razor and the Market Cycle for the arithmetic behind these historically reliable estimates). Recent weeks mark the first time in history that our estimates of prospective 10-year returns on all conventional asset classes have simultaneously declined below 2% annually. We don’t expect a portfolio mix of stocks, bonds and cash to achieve any meaningful return over the coming 8-year period. The fact that the financial markets feel wonderful right now is precisely because yield-seeking speculation and monetary distortions have raised security prices today to levels where they are likely to stand years from today – with steep roller-coaster rides in the interim.
The statement that began with the word “Unless” in the first paragraph is enormously important – because that distinction captures the primary lesson of our own awkward transition from 2009 to mid-2014 in our methods of estimating market return/risk profiles (see A Most Important Distinction, and A Better Lesson than This Time is Different).
It's important to recognize why the present syndrome of overvalued, overbought, overbullish conditions differs from other (though less extreme) syndromes that have emerged in recent years. The central distinction is the condition of investor risk preferences, as inferred from market internals and credit spreads. Even in the half-cycle since 2009, these considerations have correctly distinguished overvalued conditions that extended further from overvalued conditions that were quickly corrected (as we observed in 2010 and 2011). When investors are risk-seeking, they tend to be risk-seeking in everything, so one observes substantial uniformity in the breadth and leadership of market action across industries, sectors, capitalizations, quality, junk and various security types. Divergence and dispersion in that market action is an important and leading signal of increasing risk aversion among investors, and it is in that context that overvaluation, overbought conditions, overbullish sentiment, and compressed risk premiums often suddenly matter with a vengeance, where they didn’t seem to matter at all before.
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