Three Factors

Having extensively detailed my concerns about market conditions in prior comments, my impression is that the best course at present is to discuss the status of the more important elements of our discipline. Overall, my impression remains that the market is in the process of tracing out the blowoff finale of the third speculative financial bubble since 2000. Still, as is true for the market cycle as a whole, the broad outline of this top formation is likely to be shaped by three factors: 1) valuations, which primarily affect total market returns over a 10-12 year horizon, as well as the magnitude of potential losses over the completion of the market cycle; 2) the uniformity or divergence of market internals across a broad range of stocks and security-types, which remains the most reliable measure we’ve identified of the psychological preference of investors toward speculation or risk-aversion (when investors are inclined to speculate, they tend to be indiscriminate about it); and 3) overextended market action highlighting extremes of speculation or fear - in the advancing portion of the market cycle, these are best identified by syndromes of overvalued, overbought, overbullish conditions.

Recall the central lesson and adaptation we had to introduce during the recent advancing half-cycle, as a result of deranged central bank intervention: in prior market cycles across history, “overvalued, overbought, overbullish” syndromes could be immediately relied on as a warning of steep and abrupt market losses. In the recent half-cycle, however, investors became compelled that zero interest rates created a situation where there was no alternative to equities, and yield-seeking speculation persisted long after even the most extreme “overvalued, overbought, overbullish” syndromes emerged. In the presence of zero interest rates, one had to wait for market internals to deteriorate explicitly, before adopting a hard-negative market outlook.

Put simply, in prior market cycles across history, a hard-defensive outlook was appropriate either when rich valuations were joined by divergent market internals, or at the point that severely “overvalued, overbought, overbullish” syndromes emerged. In the presence of zero interest rates, however, “overvalued, overbought, overbullish” syndromes were not enough, and had to be explicitly prioritized behind our measures of market internals.

Understand that distinction, and you understand virtually everything that was necessary to avoid our own difficult experience in the recent half-cycle, without losing the capacity of our discipline to anticipate the 2000-2002 and 2007-2009 collapses, which we demonstrated in real-time; without losing the capacity to adopt a constructive outlook at the point that a material retreat in valuations is joined by an early improvement in market action, which I’ve done after every bear market decline in over 30 years as a professional investor (though my late-2008 shift was truncated by my insistence on stress-testing our methods against Depression-era data); without losing the capacity to tolerate an extended further market advance if the recent period of speculation continues; and without abandoning the capacity to avoid what we fully expect to be extraordinary market losses over the completion of the current cycle.

Three factors

Valuations: From a long-term and full-cycle standpoint, I continue to view current market valuations as obscene. Based on measures we find most tightly correlated with both actual subsequent 10-12 year S&P 500 total returns, and prospective market losses over the completion of the market cycle, the outlook for investors is easily the second most offensive in history. From the standpoint of individual stocks, the median price/revenue ratio of S&P 500 components is now more than 50% beyond the 2000 extreme, and establishes the present moment as the single most extreme point of broad market overvaluation in U.S. history.

The chart below offers a good sense of where current valuations stand from a historical perspective. Our most reliable measures range between 135-165% above historical norms that have regularly been visited or breached during the completion of market cycles across history, including those featuring relatively low interest rates. I’ve extensively reviewed the “justified” impact of interest rates on valuations, so I won’t review that analysis here, except to reiterate that the argument is vastly overstated, and does nothing to change the dismal prospects of the equity market in the coming 10-12 years.

From the standpoint of downside risk over the completion of the current cycle, merely touching historically run-of-the-mill valuations in the next few years would presently require a decline in the S&P 500 on the order of 57-62%. Even coming within 25% of historical norms (which no market cycle in history has failed to revisit, even since 2000) would require a market decline on the order of 47-53%. Suffice it to say that a 50-60% loss in the S&P 500 over the completion of the current market cycle would not be a “worst case” scenario, but instead a run-of-the-mill outcome.