The single most extreme syndrome of “overvalued, overbought, overbullish” conditions we identify (see Speculative Extremes and Historically Informed Optimism) was restored last week; a secondary signal at a level on the S&P 500 that’s 4% higher than the syndrome we observed in July. Recall that with one exception, that most extreme variant has only emerged at the market peaks preceding the worst collapses in the past century. Prior to the advance of recent years, the list of these instances was: August 1929, the week of the bull market peak; August 1972, after which the S&P 500 would advance about 7% by year-end, and then drop by half; August 1987, the week of the bull market peak; July 1999, just before an abrupt 12% market correction, with a secondary signal in March 2000, the week of the final market peak; and July 2007, within a few points of the final peak in the S&P 500, with a secondary signal in October 2007, the week of that bull final market peak.
The single exception was a set of signals between late-2013 and early-2014. While we’ve learned not to fight “overvalued, overbought, overbullish” extremes in zero-interest rate environments where market internals are uniformly favorable, we presently observe a situation much like the final peaks of the 1929, 1972, 1987, 2000 and 2007 bull markets, when those mitigating factors were not in place.
Our long-term and full-cycle views remain solidly negative, but our views regarding shorter segments of the market cycle are more flexible than investors may imagine. Our near-term outlook continues to be dependent on the risk-preferences of investors. The best measure of those preferences is the behavior of market internals across a wide variety of securities, industries, sectors, and security types, because when investors are risk-seeking, they tend to be indiscriminate about it. Presently, market conditions are most consistent with a “blowoff” to complete the extended top-formation of the third financial bubble in 16 years. However, an improvement in market internals would encourage us to give a longer leash to this speculation, and we will align our outlook as conditions change.
Drawing the right lesson
Prior market peaks across history had a key regularity: the emergence of extreme “overvalued, overbought, overbullish” syndromes was regularly accompanied or immediately followed by deterioration in market internals, so those syndromes alone were enough to warrant a hard-negative market outlook. Our difficult experience in the recent half-cycle resulted from my insistence in 2009 on stress-testing our methods against Depression-era data, because the resulting methods of classifying market return/risk profiles picked up that historical regularity. Our defensive response to persistently overvalued, overbought, overbullish conditions turned out to be our Achilles Heel in the face of QE. The central lesson was not that overvalued, overbought, overbullish extremes are irrelevant, but that in the face of zero-interest rates, one had to wait for market internals to deteriorate explicitly before adopting a hard-negative outlook. We adapted our approach in mid-2014 to address that issue, which is why we’re keenly focused on market internals here (see the “Box” in The Next Big Short for the full narrative).
Be careful to draw the correct lesson. It’s not that obscene valuations or syndromes of extremely overextended conditions are irrelevant for long-term and full-cycle market outcomes; it’s that the uniformity or divergence of market internals is critical in evaluating shorter segments of the market cycle. Put simply, what concerns us most here is the fact that we’re observing extreme overvalued, overbought, overbullish conditions in combination with unfavorable market internals on our measures, including yield pressures across interest-sensitive securities.
While our short-term outlook may shift with changes in the quality of market action, the long-term and full-cycle market outlook, in our view, is unavoidably disastrous. We’ve long argued, and continue to assert, that the most historically reliable measures of market valuation are far beyond double their historical norms. At current market levels, our estimate for 12-year S&P 500 average nominal total returns has collapsed to just 0.8% annually. Among the valuation measures most tightly correlated across history with actual subsequent S&P 500 total returns, the ratio of market capitalization to corporate gross value added would now have to retreat by nearly 60% simply to reach its pre-bubble average.