If there’s any point in U.S. stock market history, next to the market peaks of 1929 and 2000, that has deserved a time-stamp of speculative euphoria that will be bewildering in hindsight, now is that moment. Perhaps there’s room for this burning wick to shorten further, but across every effective, value-conscious, historically-informed classification method we use, the estimated downside risk of the market overwhelms its upside potential. The chart below shows monthly candlesticks for the S&P 500 Index since 1996, including the tech bubble and collapse, the Fed-induced mortgage bubble and collapse, and the speculative first half of the current, wholly uncompleted cycle. I believe the equity market now faces the likelihood of deeper losses over the completion of this cycle than any other in history, save for the collapse that followed the 1929 peak.
The post-election advance has taken the S&P 500 Index nearly 9% above its May 2015 high, yet internal divergences have persisted, particularly among interest sensitive sectors and security-types, along with other features such as deteriorating price/volume characteristics, leadership, and participation on new highs. I continue to view the recent advance as more consistent with a transient speculative blowoff than a durable breakout in market action. Even before the election, steep market losses over the completion of this cycle were already likely, as a consequence of obscene overvaluation baked in the cake by years of yield-seeking speculation. The election outcome only added a caboose to the back of a freight train already headed toward that cliff.
The difference between value-conscious investors and speculators is that when they encounter a sign that says “Warning! Dynamite” and see a lit wick at their feet, every inch the wick shortens is a signal for the value investor to step further away. The speculator instead moves closer, taking the delayed consequences as evidence that it’s different this time, and the sign is wrong. There have certainly been longer and shorter wicks, but ultimately, the consequences have always arrived.
On valuations, earnings, and taxes
We can’t be certain that current extremes won’t be eclipsed, as higher valuations were observed for nearly three months approaching the March 2000 market peak (based on measures that have the strongest correlation with actual subsequent returns in market cycles across history). Still, we don’t encourage relying on that as a target. The 2000 bubble peak was dominated by a subset of large-capitalization technology stocks that were breathtakingly overvalued, while median valuations across all components of the S&P 500 were less extreme. See Sizing Up the Bubble for a reminder of those skewed valuations. Last week, one of the self-fashioned carnival barkers of financial television compared the 5 stocks with the largest market capitalizations at the height of the tech bubble with the 5 largest stocks today, “to prove once and for all” that the market is not overvalued. This conflates an argument about valuation skew with an argument about valuation levels.
The fact is that the present speculative episode features what are already the most extreme median stock valuations in history. Indeed, even the richest two deciles of the S&P 500 are more extreme than those same two deciles were outside of any point in history other than the year 2000 itself. The chart below begins in 1986, when market valuations were fairly close to the pre-bubble norm of 0.8 for the S&P 500 price/revenue ratio. Even if market valuations never fall below historical norms again, the current speculative episode is likely to end badly.
The late-1990’s bubble focused the greatest distortion on technology and internet stocks, and was followed by a -50% loss in the S&P 500 and an -83% collapse in the tech-heavy Nasdaq 100. The next bubble into 2007 was broader, but was still dominated by financial and mortgage-related speculation. That bubble was followed by a 55% loss in the S&P 500 during the global financial crisis. The current bubble has been driven by years of Fed-induced yield-seeking speculation, and has infected risk assets from global debt, to junk bonds, to every corner of the equity market. My friend Jesse Felder of The Felder Report appropriately calls this the “everything bubble.”