High Risk and Low Conviction

Since everyone is probably drowning in pre-election opinions, I decided that a brief comment focused on key considerations might be welcome. While the extent of the market retreat from the August peak has been quite shallow, a variety of short-term technical indicators appear “oversold” because the recent decline has breached the narrow trading range that has prevailed in recent months. From a cyclical perspective, however, the most historically reliable market valuation measures remain so extreme that a 40-55% loss in the S&P 500 would be only historically run-of-the-mill completion of this market cycle.

Short-term oversold conditions offer a sense of potential knee-jerk dip-buying behavior, but the conviction of that behavior is often fairly weak and short-lived. Meanwhile, extreme valuations imply the likelihood of steep market losses over the complete cycle, and also for poor S&P 500 total returns on a 10-12 year horizon, but valuations often have little effect on near-term market behavior. Instead, the behavior of the market over shorter segments of the cycle is driven not only by valuations but also by the preference of investors toward risk-seeking or risk-aversion. That’s really the aspect of present conditions that now gives extreme valuations their bite. Investor risk-preferences, as conveyed by the uniformity or divergence of market internals, are the hinge between overvaluation that persists and overvaluation that devolves into air pockets, free-falls, and crashes. Given that deteriorating market internals (particularly since mid-September) have continued to suggest increasing risk-aversion among investors, it’s not at all clear that short-term “oversold” measures will provide much support. For our part, we continue to classify market conditions among the most hostile market expected return/risk profiles we’ve identified across history. Regardless of the potential for a near-term “relief rally,” our defensive market view is likely to shift only as the combination of valuations and market action improve.

Last week, the S&P 500 retreated to its 200-day moving average. On one hand, this is a natural point for dip-buyers to offer support. On the other hand, a breach of that support would be an equally natural point that could trigger coordinated exit attempts by trend-followers. At the August peak (see Looking Ahead to a Bullish Outlook, and What Will Define It), I noted that the position of the S&P 500 relative to its 200-day moving average is not what defines favorable market action or our overall market return/risk classification. Indeed, once our estimated market return/risk profile is strictly negative (as it is at present), the negative implications for the S&P 500 aren’t affected by the position of the market relative to that average, except that the market tends to experience higher volatility once the market breaks that average. I observed, “The main reason to track the 200-day average here is because it is a widely-referenced trend-following pivot. A decline much more than 2% below that average could provoke coordinated exit attempts by trend-followers, at valuations nowhere near the point where value-conscious investors would be eager to absorb those shares.”