The Illusion that "Old Measures No Longer Apply"

“The recent collapse is the climax, but not the end, of an exceptionally long, extensive and violent period of inflation in security prices and national, even world-wide, speculative fever. This is the longest period of practically uninterrupted rise in security prices in our history... The psychological illusion upon which it is based, though not essentially new, has been stronger and more widespread than has ever been the case in this country in the past. This illusion is summed up in the phrase ‘the new era.’ The phrase itself is not new. Every period of speculation rediscovers it... During every preceding period of stock speculation and subsequent collapse business conditions have been discussed in the same unrealistic fashion as in recent years. There has been the same widespread idea that in some miraculous way, endlessly elaborated but never actually defined, the fundamental conditions and requirements of progress and prosperity have changed, that old economic principles have been abrogated... and that the expansion of credit can have no end.”

The Business Week, November 2, 1929

“The market will not go on a speculative rampage without some rationalization. But during any future boom some newly rediscovered virtuosity of the free enterprise system will be cited. It will be pointed out that people are justified in paying the present prices - indeed, almost any price - to have an equity position in the system. The newspapers, some of them, will speak harshly of those who think action might be in order. They will be called men of little faith.”

John Kenneth Galbraith, The Great Crash, 1955

“The failure of the general market to decline during the past year despite its obvious vulnerability, as well as the emergence of new investment characteristics, has caused investors to believe that the U.S. has entered a new investment era to which the old guidelines no longer apply. Many have now come to believe that market risk is no longer a realistic consideration, while the risk of being underinvested or in cash and missing opportunities exceeds any other.”

Barron’s Magazine, February 3, 1969. The S&P 500 had already started a bear market a few weeks earlier, which would take stocks down by more than one-third over the next 18 months. The S&P 500 Index would stand below its 1968 peak even 14 years later (with a real average annual total return of -3.4%, after inflation, over that period).

“Old ways of valuing stocks are outdated. A technological revolution has created opportunities for continued low inflation, expanding profits and rising productivity. Thanks to these factors, the United States may be able to enjoy an extended period of expanding stock prices. Jumping out now would leave you poorer than you might become if you have some faith.”

Los Angeles Times, May 11, 1999

In early 2000, the most reliable valuation measures we identify had reached extremes previously seen only at the 1929 peak, and were well beyond lesser extremes such as 1937, 1969, and 1972. At the time, I observed “the issue is no longer whether the current market resembles those preceding the 1929, 1969-70, 1973-74 and 1987 crashes. The issue is only - are conditions like October of 1929, or more like April? If the latter, then over the short-term, arrogant imprudence will continue to be mistaken for enlightened genius, while studied restraint will be mistaken for stubborn foolishness. The difficult part of all this is the short term. I have no answer for that, except that in each prior instance, every scrap of short term gain was wiped out in the eventual downturn. Let’s not be shy: regardless of short-term action, we ultimately expect the S&P 500 to fall by more than half, and the Nasdaq by two-thirds. Don’t scoff without reviewing history first.”

As it happened, from March 2000 to October 2002, the S&P lost half of its value and the Nasdaq 100 lost 83%. In the 7 years from the 2000 peak to the 2007 market peak, the S&P 500 achieved an average annual total return of just 2.1%. In the 9 years following the 2000 peak, the S&P 500 not only lost all of its interim gains, but also fell -48% below that 2000 peak on a total return basis. It was not until August 2012 that the S&P 500 recovered to a zero total return as measured from the March 2000 peak, taking until April 2013 for the S&P 500 to manage a positive real total return after inflation. It has required the third speculative episode in 16 years for the S&P 500 to claw out even a 4% average annual total return from the 2000 peak.

Unfortunately, given current valuation extremes, we fully expect the entire total return of the S&P 500 since 2000 to be wiped out over the completion of the present market cycle. That loss is likely to be an interim low on another journey to nowhere, ultimately leading the S&P 500 to an estimated total return averaging less than 1.5% annually over the coming 12-year period. There are certainly extended segments of history - even during the period since 2000 - when stocks have been rewarding investments; particularly measured from points where valuations were depressed to points where they became elevated. But to believe that stocks are a rewarding investment, regardless of valuation, is to ignore a century of history.

I’ll pause here for an essential reminder. The central lesson of the QE-induced “everything bubble” was that, in the face of zero interest rates, even extreme syndromes of overvalued, overbought, overbullish conditions were not enough to reward a hard-negative market outlook (as they had been in prior cycles across history). Instead, the key adaptation was this: in the face of zero interest rates, one had to wait until market internals deteriorated explicitly, indicating a shift toward increasing risk-aversion among investors, before taking a hard-negative view (see the “Box” in The Next Big Short for a more detailed discussion). As I noted in Support Drops Away, our concerns about that "market action" component have substantially increased in recent weeks. Conversely, in the event that market internals improve meaningfully, our view would become more neutral, despite what we see as obscene valuations here.

As I’ve regularly observed over time, the strongest market return/risk profiles typically emerge when a material retreat in valuations is joined by an early improvement in measures of market action. That combination would provide the best opportunity to expand market exposure. Despite our expectation that the present market cycle will be completed by a 40-55% loss, we have no requirement for that to occur as a prerequisite to taking a more constructive outlook. Instead, our classification of the market return/risk profile will shift as the observable evidence does. If we have any preference at all, it’s for a sufficiently larger range of market fluctuation to produce variations in the market return/risk classifications we identify, which would allow for greater variation in our market outlook.