As we look forward to 2016, to following through on our investment discipline over the completion of the current market cycle and beyond, a few recent market comments will serve as a detailed review of our present market and economic outlook:
The summary of this outlook is straightforward. I view the equity market as being in the late-stage top formation of the third financial bubble in 15 years. Based on a century of evidence relating the most historically reliable valuation measures to actual subsequent market returns, neither a market plunge of 40-55% over the completion of the current cycle, nor the expectation of zero 10-12 year S&P 500 nominal total returns, nor the likelihood of substantially negative 10-12 year real returns should be viewed as worst-case scenarios - they are all actually run-of-the-mill expectations from current extremes. Based on the joint behavior of the most reliable leading economic measures (particularly new orders plus order backlogs, minus inventories), widening credit spreads, and clearly deteriorating market internals, our economic outlook has also moved to a guarded expectation of a U.S. recession.
Valuations: With regard to current market valuations, and what we view as the likely prospect of zero nominal and negative real S&P 500 total returns over the coming 10-12 years, see Rarefied Air: Valuations and Subsequent Market Returns and The Bubble Right in Front of Our Faces.
Recession: On the economic front, the basis for my increasing expectation of oncoming recession is summarized in From Risk to Guarded Expectation of Recession.
Fed Policy: On the past and anticipated impact of Federal Reserve actions, see Deja vu: The Fed’s Real Policy Error Was to Encourage Years of Speculation, and Reversing the Speculative Effect of QE Overnight.
Market Internals: Also, to openly recognize the awkward transition that followed my 2009 insistence on stress-testing our methods of classifying market return/risk profiles against Depression-era data, to detail the significant challenges that followed, and to underscore the central lesson involving market internals (lest investors infer the dangerously incorrect alternative that valuations don’t matter or that the Fed can always support the market - notions that should be dismissed even by examining the 2000-2002 and 2007-2009 collapses), see The Hinge, Voting Machine - Weighing Machine, Valuation and Speculation: The Iron Laws, and A Better Lesson than “This Time is Different.”
I’ll emphasize once again that the behavior of market internals across a broad range of individual stocks, industries, sectors, and credit-sensitive securities is a “hinge” that distinguishes bubbles that continue from bubbles that crash; Fed easing that supports the market from Fed easing that proves ineffective; and economic deterioration that stabilizes and recovers from economic deterioration that unravels into recession. While many of our long-term concerns would persist regardless of the behavior of market action (as an improvement in internals at these levels would not make reliable valuation measures any less extreme), the immediacy of our concerns would be substantially reduced in the event that market internals were to improve. Ideally, such an improvement will follow a material retreat in valuations; a combination which has historically represented the best opportunity in the market cycle to shift toward an aggressive exposure to stocks.
Full-cycle market dynamics
From the standpoint of full-cycle market dynamics (which include not just bull market gains but also the bear market losses that have regularly wiped out more than half of the those gains over the completion of the typical cycle), I view two features as most important. First, valuations are the primary driver of long-term market returns. The most reliable valuation measures in market cycles across history are those that mute or otherwise account for cyclical variation in profit margins. As the legendary value investor Benjamin Graham observed, the worst investment losses typically result from the assumption that good business conditions can be priced into stocks as if they are permanent: “purchasers view the good earnings as equivalent to ‘earning power’ and assume that prosperity is equal to safety.”
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