More Blowoff than Breakout

We continue to view the equity market as tracing out an extended two-year top formation, at what is presently the third most extreme level of market overvaluation in history. Enthusiasm about a runaway market “breakout” to the upside is clearly evident in fresh sentiment extremes, with advisory bullishness rising to 55.9% and bearishness down to 21.6% (Investors Intelligence), but the fact is that the S&P 500 Index closed Friday less than 4% above its May 2015 high, and just 1% above its August 2016 high. The broader NYSE Composite Index remains below the level it set in July 2014, though with a slightly positive return including dividends. The stock market has reestablished an extreme overvalued, overbought, overbullish syndrome of conditions that - unlike much of half-cycle advance from 2009 to mid-2014 - lacks internal uniformity, particularly among interest-sensitive and globally-sensitive sectors. For that reason, the recent marginal highs are more consistent with a “blowoff” than a “breakout.”

From a short-term perspective, it’s important to emphasize that if market internals were to become more uniformly favorable, we could infer a more robust shift toward risk-seeking among investors. That, in turn, could encourage a more neutral or constructive near-term view despite offensive valuations. As the data stand, however, the recent post-election advance appears much like the post-Brexit rally in global markets, where nearly all of the gains were compressed in the first 12 trading days, after which the enthusiasm flamed out.

Frankly, regardless of how market action plays out on a shorter horizon, I still expect the S&P 500 to surrender its entire total return since 2000 over the completion of the current market cycle. The interim returns are likely to represent little but temporary paper gains, except for investors who exit. Even in that event, some other investor would then be in the position of holding the bag. In aggregate, the U.S. equity market is unlikely to avoid a roughly $10 trillion paper loss by the completion of this market cycle.

The chart below shows a 10-year view of the FTSE All-World Index, which represents about 95% of tradeable global equity market capitalization. This profile also remains consistent with an extended top formation, following a broad peak in mid-2015. I’m certainly not tied to that view, but again, an improvement in market internals across a wider range of security types and sectors would be the main reason to adopt a more balanced outlook.

All of the most reliable equity market valuation measures we track (as measured by their relationship with actual subsequent market returns across history) are offensively overvalued from a long-term and full-cycle perspective. The most accurate measure we’ve developed over time - the ratio of U.S. nonfinancial market capitalization to corporate gross value-added - has now marginally eclipsed its 2015 high, placing it at a level consistent with expectations of S&P 500 12-year nominal total returns averaging less than 1% annually.

Having driven valuations to current extremes almost exclusively on the basis of yield-seeking speculation, it’s somewhat ironic that Wall Street analysts are now suggesting that the new administration will bring higher GDP growth that will presumably enable valuations to be sustained or extended, despite higher interest rates. Unfortunately, even if we enjoy faster economic growth with only marginally higher interest rates, we already know that those same economic conditions have historically been associated with market valuations averaging less than half of present levels (though those lower valuations would come with the corresponding benefit of 12-year expected stock market returns centered around 10% annually, rather than the current 1%).