As anyone who has been along with me in recent years can probably recite by heart, the challenges we’ve addressed since 2009 can be traced to two elements: 1) my unfortunately-timed insistence on stress-testing our methods against Depression-era data – what I described at the time as our “two data sets” problem – which resulted in missing returns in the interim that both our existing methods and our pre-2009 methods could have captured, and 2) the need to adapt to the legitimate difference between the present cycle and historical ones: the tendency for extremely overvalued, overbought, overbullish syndromes to extend much further than in prior market cycles, without material correction, as a result of Fed-induced yield seeking by speculators with little regard for valuation.
The main area that remained for improvement as we entered 2014 related to item 2), which I discussed in September 2013 (see The Lesson of the Coming Decade). In prior market cycles, extreme overvalued, overbought, overbullish conditions had almost invariably resulted in steep and abrupt market declines in relatively short order, though often with what I call “unpleasant skew” – a few weeks of small but persistent marginal new highs followed by an abrupt plunge that would wipe out weeks or months of gains in a few sessions. On that aspect, “this time” has been legitimately different.
We nailed down the necessary distinction earlier this year, as I described in Formula for Market Extremes. It’s instructive that in periods where overvalued, overbought, overbullish syndromes have overlapped deteriorating market internals or widening credit spreads,even since 2009 and during periods of QE, stocks have lost considerable value (see A Most Important Distinction).
The May 12, 2014 comment, Setting the Record Straight includes a reasonably full account of the factors that made the half-cycle since 2009 different from our experience in prior, complete market cycles. The main comment I would add is that we’ve addressed these challenges, the lessons were hard-won, and nobody in their right mind should imagine that they have not been incorporated into our work.
I hear that I'm a polarizing figure in internet chat circles. While I write a lot of market commentary, I rarely read comments on social media, following Neil Stephenson’s rule that “arguing with anonymous strangers on the Internet is a sucker’s game – they turn out to be indistinguishable from self-righteous sixteen-year-olds with infinite free time.” If you’re writing in defense of my work, please be civil (thanks in particular for thoughtful comments from Jeremy Grantham of GMO, and David Horn, a professor of value investing at Columbia). If you’re writing to throw stones, please at least read my commentaries and focus on things I haven't refuted with evidence or recognized, admitted, and addressed, as I’ve been quite open about the challenges we’ve encountered since 2009, and my part in them. I certainly deserve some criticism – some of the damage to my reputation in this half-cycle was self-inflicted, and despite the adaptations we’ve made, we haven’t yet erased the scars. Given extreme bullish sentiment and the necessity of justifying prices that are so disconnected from historically reliable valuation measures here, it’s also not a surprise that value-conscious, historically-informed views are increasingly polarizing. As George Orwell wrote, “The further a society drifts from truth, the more it will hate those who speak it.”
Meanwhile, the S&P 500 is more than double its historical valuation norms onreliable measures (with about 90% correlation with actual subsequent 10-year market returns), sentiment is lopsided, and we observe dispersion across market internals, along with widening credit spreads. These and similar considerations present a coherent pattern that has been informative in market cycles across a century of history – including the period since 2009. None of those considerations inform us that the U.S. stock market currently presents a desirable opportunity to accept risk.
If market internals and credit spreads improve, our immediate concerns will become less pointed, but it won’t make stocks any cheaper, so various safety nets will still be essential to guard against fresh deterioration. For now, our concerns about market risk are as severe as they were at the 2000 and 2007 peaks, and these concerns are equally dismissed and reviled, which is oddly encouraging.
Some have marveled that we can be so faithful to our investment discipline despite having been incorrect about the persistence of this speculative advance in recent years. Understand this: I know exactly what went wrong in 2009-2010 - we missed returns thatboth our pre-2009 methods and present methods could have captured, in the interim of a necessary but unfortunately-timed decision to stress-test our approach against Depression-era data; I know exactly the challenge that Fed-induced yield-seeking has posed to our discipline in recent years - and how we’ve addressed it by overlaying our ensemble approach with criteria related to factors such as credit spreads and trend uniformity. Neither of these challenges remains an obstacle here.
Equally important, I know exactly the conditions under which our approach has repeatedly been accurate in cycles across a century of history, and in three decades of real-time work in finance: I know what led me to encourage a leveraged-long position in the early 1990’s, and why were right about the 2000-2002 collapse, and why we were right to become constructive in 2003, and why we were right about yield-seeking behavior causing a housing bubble, and why we were right about the 2007-2009 collapse. And we know that the valuation methods that scream that the S&P 500 is priced at more than double reliable norms, and that warn of zero or negative S&P 500 total returns for the next 8-9 years, are the same valuation methods that indicated stocks as undervalued in 2008-2009.
Think I should have become constructive after the market collapsed in 2008? In fact, I did.See, for example, Why Warren Buffett is Right and Why Nobody Cares. Unfortunately, I failed to contemplate the policy mistakes that would push the economy to the brink of Depression by obstructing and delaying restructuring efforts, and insisting on protecting bad private debt at public expense. If you read my market comments before and during the crisis, it should be clear that I had fully anticipated the market outcomes, but that I had also expected what I called a "writeoff recession" (which I still believe could have and should have been the outcome, had policy makers less beholden to Wall Street prevailed such as then-FDIC Chair Sheila Bair).
During the Depression, valuations similar to those of 2008 were still followed by a loss of two-thirds of the stock market’s value to its final low in 1932. My mistake was not that I insisted on stress-testing our methods against Depression-era data, but that I failed to stress-test against Depression-era data sooner, when I saw the crisis coming. Had I done so, we could have avoided our 2009-2010 miss. I can't blame policy makers for that - it's my job to create a discipline that is robust to both sound and reckless policy decisions. I believe we've achieved that, but the stress-testing transition was very awkward. Our added reliance on market internals, credit spreads and the like is useful because these measures are informative about risk-seeking and risk-aversion, regardless of the particular economic context.
As an important side note, the financial crisis was not resolved by quantitative easing or monetary heroics. Rather, the crisis ended – and in hindsight, ended precisely – on March 16, 2009, when the Financial Accounting Standards Board abandoned mark-to-market rules, in response to Congressional pressure by the House Committee on Financial Services on March 12, 2009. The decision by the FASB gave banks “significant judgment” in the values that they assigned to assets, which had the immediate effect of making banks solvent on paper despite being insolvent in fact. Rather than requiring the restructuring of bad debt, policy makers decided to hide it behind an accounting veil, and to gradually make the banks whole by lowering their costs and punishing ordinary savers with zero interest rates, creating yet another massive speculative yield-seeking bubble in risky assets at the same time. So here we are. In any event, I believe that the research, stress-testing, and adaptations we've implemented the half-cycle since 2009 leaves us prepared for a very wide range of future outcomes and policy responses.
The equity market is now more overvalued than at any point in history outside of the 2000 peak, and on the measures that we find best correlated with actual subsequent total returns, is 115% above reliable historical norms and only 15% below the 2000 extreme. Unless QE will persist forever, even 3-4 more years of zero short-term interest rates don’t “justify” more than a 12-16% elevation above historical norms. That increment can be calculated using any discounted cash flow method. Based on valuation metrics that are about 90% correlated with actual subsequent returns across history, we estimate that the S&P 500 is likely to experience zero or negative total returns for the next 8-9 years. At this point, the suppressed Treasury bill yields engineered by the Federal Reserve are likely tooutperform stocks over that horizon, with no downside risk. The only thing that keeps this from being obvious is the proclivity of Wall Street analysts to form opinions and quote indicators without actually testing whether their methods have any reliability at all in evidence from market cycles across history. Numerous popular metrics, including the “Fed Model” and price-to-forward-earnings as a measure of value, have a very weak relationship to market returns over the following quarters or years.
As was true at the 2000 and 2007 extremes, Wall Street is quite measurably out of its mind. There's clear evidence that valuations have little short-term impactprovided that risk-aversion is in retreat (which can be read out of market internals and credit spreads, which are now going the wrong way). There's no evidence, however, that the historical relationship between valuations and longer-term returns has weakened at all. Yet somehow the awful completion of this cycle will be just as surprising as it was the last two times around – not to mention every other time in history that reliable valuation measures were similarly extreme. Honestly, you’ve all gone mad.
“But I don’t want to go among mad people,” said Alice. “Oh, you can’t help that,” said the cat. “We’re all mad here.” – Lewis Carroll
I equally recognize my own faults. The lessons of the recent half-cycle certainly point to significant segments of the period since 2009 that were more supportive of a constructive stance than I encouraged in real-time. Those segments are generally found 1) in the interim of our stress-testing response to a credit-crisis that we fully anticipated (aside from policy failures that vastly worsened the economic fallout), and 2) at points in recent years where market conditions were overvalued, overbought, and overbullish, yet where market internals and credit spreads reflected little concern about risk or yield-seeking speculation.
It remains urgent to understand that the present moment is included in neither of those segments. That may change, and we’ll respond accordingly. Internal dispersion continued to show subtle signs of growing risk aversion last week, particularly Friday when yields on Treasury debt and other issues perceived as "default free" plunged, while commodity prices also plunged across the board, junk bond yields rose, and the number of individual issues setting new 52-week lows shot higher despite major indices near record highs. This market action and internal dispersion suggests growing perceptions of either a negative shock to global growth or concerns about fresh credit risk (not that those two are separable given the size of global debt burdens). With regard to the U.S., we don't observe recession warnings yet - the usual sequence features a slowdown in real sales and consumption first, then production, then personal income, and employment (a clear lagging indicator) much later. Still, we're keeping watch on our recession warning composites, as a recession in Japan, a slowdown in China, and emerging weakness in Europe are all likely to have an impact on U.S. activity.
Regardless of whether the completion of the present market cycle begins immediately or only with time, and regardless of whether a synchronized global downturn is developing or not, I view the challenges of this half-cycle since 2009 as being fully addressed. That doesn’t mean much for short-term outcomes or moderate fluctuations in the market, which are largely unpredictable (at least to our understanding). But we can identify the market return/risk profiles that were indicated by observable evidence at every point in history, and we know the value of those distinctions in identifying favorable and unfavorable conditions to accept market risk. Historically informed, value-conscious discipline provides a very coherent way to understand and navigate major cyclical fluctuations in equity prices across a century of market cycles. There's no assurance that the lessons of history will be useful in future cycles, but the alternatives are to accept every risk, or to invest by the seat of one's pants.
The bird in the hand
As usual, I have no interest in converting others to our views. Still, those who follow and trust my work should certainly feel confident that we’ve addressed the challenges we’ve encountered since 2009, and that the adaptations I’ve detailed in these comments are fully incorporated into our discipline.
More broadly, the main thing I encourage is for investors to understand the actual depth of market declines that have been part and parcel of market cycles across history (the risk is not 5-10%, but 30-50% and occasionally more, depending on the level of valuation at the peak). These must be anticipated and accepted as a part of passive investment strategies. For passive investors, I believe that for passive investment strategies that take no view at all about market direction, the average duration of one’s portfolio should be roughly aligned with the horizon over which the funds will be spent. For example, if one expects to start drawing from a portfolio 15 years from today, then spending it over 20 years, theaverage duration of the spending is something close to 25 years out.
Now, cash and short-term equivalents have a duration of roughly zero. The duration of a 10-year zero-coupon bond is 10 years. A 10-year Treasury bond with a modest coupon presently has a duration of about 9 years. A similar 30-year Treasury bond has a duration approaching 20 years. The S&P 500, at current valuations, has a duration of about 50 years (though if the S&P 500 dividend yield was closer to the historical norm of 4%, equity duration would drop to about 25 years).
Accordingly, a passive investor with no view about market direction and a 25-year average spending horizon might reasonably match that expected spending with a portfolio of 40% equities, 10% long-term bonds, 25% intermediate-term bonds, and 25% cash. My own view is that such a portfolio will likely return less than 2% annually over the coming decade, and that increasing the equity share would actually lower the expected return. That’s really what QE has done, and there is no easy solution. But then, I have a view – albeit a historically-informed one. If equity valuations were historically normal, that same investor could comfortably invest the entire portfolio in equities, and the expected long-term return would be closer to 10% or more. In environments of rich valuations and low expected returns as we observe here, my view is that portfolio allocation should shift toward greater use of alternative investments, with more conventional profiles when the reverse is true. That approach would have saved investors a great deal of distress in the past 15 years.
Again, for investors with spending horizons less than about 50 years into the future, a relatively conservative stance in equities is presently encouraged solely on the principle of matching the duration of assets to spending needs, even if one has no particular view about near-term or long-term market direction. Given current valuations, my sense is that many investors with similar spending expectations have a much greater equity exposure than is appropriate here. I certainly am not encouraging ordinary investors to sell everything, particularly those who follow a passive investment discipline. I do believe, though, that now is an extraordinarily useful time to correctly align your portfolio duration.
For those investors who take a more strategic view about likely future returns, we presently estimate prospective S&P 500 10-year nominal total returns of less than 1.4% annually. Investors are being offered the choice between a quite large and easily captured bird in the hand, or two ailing, elusive and possibly imaginary birds in the bush. Our own concerns are clear, and while the immediacy of those concerns would ease in the event market internals and credit spreads improve, the 8-10 year outlook for equity returns remains dismal, and is likely to be repaired only by the downward completion of a market cycle that we currently view as almost precisely half-completed.
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