Cassandra's Song

One of the attempted barbs tossed my way at various points in the past 20 years is “Cassandra.” Though I was often known as a leveraged “raging bull” before the late-1990’s bubble, and have regularly shifted to a constructive outlook after every bear market decline in more than 30 years as a professional investor, Cassandra’s name was called out at me approaching the bubble peaks of 2000, 2007, and again at the recent market highs. Frankly, I kind of like it.

See, in Greek mythology, Cassandra’s curse was not that her prophesies were incorrect. She understood her responsibility to defend others by sharing the future that she saw clearly. The curse was that nobody believed her until it was too late. When she warned that there were soldiers in the Trojan horse, the only person who believed her was silenced. As Robert E. Bell wrote, “her tragedy was knowing the unhappy truth and revealing it, something highly unwelcome then as now.”

Across three decades as a professional investor, we’ve always come out admirably over complete market cycles (with the clear exception of the speculative half-cycle since 2009). Even with recent challenges, we’ve never taken deeper loss during a complete market cycle than the S&P 500 has experienced. Still, the problem with recognizing the future is that one often seems wholly out-of-touch with the present. That was Cassandra’s problem too.

In March 2000, I wrote “The inconvenient fact is that valuation ultimately matters. That has led to the rather peculiar risk projections that have appeared in this letter in recent months. Trend uniformity helps to postpone that reality, but in the end, there it is... Over time, price/revenue ratios come back into line. Currently, that would require an 83% plunge in tech stocks (recall the 1969-70 tech massacre). The plunge may be muted to about 65% given several years of revenue growth. If you understand values and market history, you know we’re not joking.” The S&P 500 followed by losing half of its value by October 2002, while the tech-heavy Nasdaq 100 lost, well, 83%.

As the next bubble was getting its legs thanks to Fed-induced yield-seeking speculation, I wrote, “why is anybody willing to hold this low interest rate paper if the borrowers issuing it are so vulnerable to default risk? That's the secret. The borrowers don't actually issue it directly. Instead, much of the worst credit risk in the U.S. financial system is actually swapped into instruments that end up being partially backed by the U.S. government. These are held by investors precisely because they piggyback on the good faith and credit of Uncle Sam.” By April 2007 another bubble was fully formed, and I estimated that the market would have to lose 40% of its value simply to reach historical valuation norms. Following that 40% loss, I observed in my late-October 2008 comment that stocks had become undervalued. Neither view was popular at the time.

Despite anticipating the financial crisis, the accompanying economic consequences were “out of sample” from the standpoint of the post-war data that our market return/risk classifications relied upon, and I very admittedly stumbled as a result of my insistence on stress-testing our methods against Depression-era data (see the “Box” in The Next Big Short for the full narrative). Even so, our valuation methods were no part of that difficulty. They correctly identified stocks as undervalued in 2009 (though in the Depression, the same level of valuation was followed by stocks losing another two-thirds of their capitalization), and they’ve been just as tightly correlated with actual subsequent market returns in recent complete cycles as they have been across history.

While valuations are extremely informative about full-cycle returns and potential risks, returns over shorter segments of the market cycle are primarily driven by the inclination of investors toward risk-seeking or risk-aversion, which is best inferred from market action. The challenge in the recent half-cycle had to do with Fed-induced yield-seeking, which disrupted the historical tendency for deteriorating internals to accompany or quickly follow extreme “overvalued, overbought, overbullish” syndromes as they had in other cycles across history. In the face of zero interest rates, one had to wait for market internals to deteriorate explicitly before taking a hard-negative outlook.

Yet the fact that our valuation approach wasn’t the problem in the recent half-cycle is actually a horrible problem for investors here. See, regardless of market internals or even economic outcomes over a shorter horizon, the speculative extremes of recent years imply profound market losses in the coming years. I see these losses as both predictable and inevitable. On the most reliable measures across history, the S&P 500 presently stands between 120% and 150% above historical valuation norms (depending on which measure one chooses), and the correlation between those measures and actual subsequent market returns hasn’t deteriorated a bit in recent market cycles. Moreover, we’ve never observed a market cycle across history, even at the relatively kind 2002 lows, when these measures did not get within 25% of those norms (usually the completion of a market cycle takes valuations moderately to well-below those norms).