Salient Features of Bull Market Peaks

Last week, the S&P 500 price/revenue ratio reached the highest level in history, outside of the single week of March 24, 2000 that represented the peak of the tech bubble. Meanwhile, the 30-day CBOE volatility index (largely reflecting the level of fear or complacency among option traders) dropped to a record low, as bullish sentiment surged to 57.8% bulls versus 16.7% bears (Investors Intelligence), and the S&P 500 pierced its upper Bollinger bands (two standard deviations above a 20-period moving average) on daily, weekly, and monthly resolutions.

Today’s offensive valuations establish the likelihood of zero or negative S&P 500 total returns over the coming 10-12 year horizon, and steep interim market losses over the completion of the current market cycle, but those are long-term and full-cycle considerations. From the standpoint of shorter segments of the market cycle, it’s equally important that aside from wicked market overvaluation and the most extreme overvalued, overbought, overbullish syndromes we identify, we also continue to observe dispersion across our measures of market internals (which we use to infer changes in the inclination of investors toward speculation or risk-aversion).

I’ve extensively detailed how the Federal Reserve’s deranged pursuit of zero interest rates in the recent half-cycle disrupted the historical reliability of “overvalued, overbought, overbullish” syndromes as sufficient indicators of imminent, steep, and abrupt market declines. In the presence of zero interest rates, one had to wait for market internals to deteriorate explicitly, before adopting a hard-negative outlook. See When Valuations Don’t Seem to “Work” for a review of that narrative, the challenges it created for us in the recent half-cycle, and how we adapted. Take a moment to review the chart that appeared at the bottom of that commentary. The only addition to that chart is that the S&P 500 has now extended this advance enough to pierce its upper Bollinger bands at daily, weekly, and monthly resolutions.

There are many conditions that differ at various market peaks across history, including the behavior of interest rates, economic measures, inflation and other factors. For example, core inflation was just 2% and falling at both the 2000 and 2007 peaks. Credit spreads were low and falling at the 1966, 1972, and 1987 market peaks. We do find that rising credit spreads are among the conditions that generally accompany recessions, but they can emerge well after the stock market sets its high. Indeed, even for bear markets that are associated with recessions, convincing evidence of a recession typically does not emerge until well into those declines.

Given various factors that are observable at each point in time, the central question is always whether they are salient, in the sense that they project outward, modifying or dominating other conditions enough to systematically affect subsequent market outcomes.

We know, for example, that low interest rates and Fed easing are actually salient only to the extent that they are consistent with the behavior of market internals (see When Fed Easing Helps Stocks, and When It Doesn’t. When market internals are uniformly favorable across a broad range of securities and asset classes, Fed easing strongly amplifies the bullish tendencies of the market, particularly when valuations are favorable, or "overvalued, overbought, overbullish" syndromes are absent. By contrast, as long as market internals remain uniformly favorable, even Fed tightening is associated with market gains, on average. Conversely, when market internals are unfavorable or feature internal dispersion, as they did through 2000-2002 and 2007-2009 market collapses, even the most aggressive and persistent easing by the Fed does not support stocks. Indeed, when market internals are uniformly unfavorable, market losses are worse when the Fed is easing than when it is not.

The explanation for the market’s conditional response to Fed easing is straightforward. Uniformly favorable market internals are a signal that investors are inclined to speculate and accept market risk. In that environment, low-interest liquidity is viewed by investors as an inferior asset and a “hot potato.” Creating a larger pool of these inferior assets contributes to even greater yield-seeking speculation.

In contrast, as investors ought to remember from 2000-2002 and 2007-2009, once investors become risk-averse, low-interest liquidity is viewed as a desirable asset. In a risk-averse environment, creating safe, low-yielding liquidity is quite welcome, but does nothing to encourage risk-seeking behavior. In fact, the market experiences particularly steep losses when the Fed eases during “risk-off” conditions, because that easing is typically a response to ongoing economic deterioration.