Cutting immediately to the chase, the U.S. equity market is in a late-stage top formation of the third speculative bubble in 15 years. On the basis of measures best correlated with actual subsequent Standard & Poor's 500 total returns across history, equity valuations remain obscene. A loss in the S&P 500 in the range of 40% to 55% over the completion of this cycle seems likely –Â an outcome that would be wholly run of the mill, given present market conditions, and would not even bring reliable measures of valuation materially below their longer-term historical norms.
Following the steep but relatively contained market plunge in August, the major indices rebounded toward their May highs, but neither the broad market nor high-yield credit participated meaningfully. Only 34% of individual stocks remain above their respective 200-day averages, widening credit spreads suggest growing concerns about low-quality debt defaults, and sectoral divergences (e.g. relative weakness in shipping vs. production) confirm what we observe in leading economic data — a buildup of inventories and a shortfall in new orders and order backlogs. Employment figures lag the economy more than any other series.
When investors are seeking risks, they tend to be indiscriminate about it. If market internals were uniformly favorable, suggesting that investors remained inclined toward yield-seeking speculation, we could at least expect that continued speculation might defer immediate market losses, or possibly drive valuations to even more offensive levels. Fed easing (or the decision not to raise rates) might be bullish in that environment. But as investors should recall from Fed easing in late 2007 and early 2001, just as market collapses were beginning, Fed easing is among the most bearish possible events when it occurs in an environment of rich valuations and unfavorable market internals, as such easing is typically provoked by concern about economic deterioration.
In the absence of favorable internals, we conclude not only that risk premiums in equities are razor thin, but that the continued shift toward risk-aversion among investors leaves the market vulnerable to abrupt spikes in risk premiums. This is an environment that has historically left the market open to vertical air-pockets, panics and crashes.
The bubble right in front of our faces
Investors don’t like to acknowledge bubbles. And because they’ve been so prone to deny them, bubbles (and their consequences) have become a recurring part of the financial landscape over the past two decades. During the late-1990s technology/dot-com bubble, debt-financed malinvestment was mainly directed toward Internet-related companies. The end result was a collapse in the Nasdaq 100 of -83%, while the S&P 500 lost half its value. By the 2002 low, the entire total return of the S&P 500 — in excess of Treasury bills — had been wiped out, all the way to back May 1996.
It has taken yet another full-fledged multiyear speculative bubble to get the Nasdaq back to even (most likely only temporarily), and to bring the total return of the S&P 500 since 2000 to even 4% (again, most likely only temporarily). By the completion of the current market cycle, we fully expect that the total return of the S&P 500 since the 2000 peak will fall to zero or negative levels for what will then be a roughly 17-year span, and that the S&P 500 will have underperformed Treasury bills all the way back to roughly 1998 –Â what will then be a nearly 20-year span.
As a reminder of how unwilling investors are to acknowledge bubbles, one must remember that in 2000, even before the S&P 500 reached its final bull market high on a total-return basis, a broad range of dot-com stocks had already collapsed by about 80% from their own 52-week highs. Investors were finally willing to acknowledgethat bubble only after it collapsed, but somehow continued to believe that the bubble was contained only to dot-com companies, and continued to push the S&P 500 higher. Consider this gem from the Wall Street Journal, which appeared in July 2000 with the title “What were we thinking?”
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