At the height of the technology bubble, the median of the most reliable market valuation measures we follow (those most strongly correlated with actual subsequent S&P 500 total returns) briefly reached an apex 178% above historical norms that had been regularly approached or breached over the completion of every market cycle in history. That level of valuation implied a prospective market loss of (1/(1+1.78)-1 = ) -64% as the bubble collapsed. In real-time, I suggested, based on related measures, that prospective market losses would likely be tiered, with tech stocks losing about -83%, the S&P 500 losing more than half of its value. As it happened, the 2000-2002 collapse took the S&P 500 down by 50%, while the tech-heavy Nasdaq 100 Index lost an oddly precise -83%. Smaller capitalization stocks suffered less extensive losses due to better valuations, as they had materially lagged the large-cap indices during the late-stages of that bubble.
Attempting to “stimulate” the economy from the recession that followed, the Federal Reserve cut short-term interest rates to just 1%, provoking an episode of yield-seeking speculation, where yield-starved investors created demand for higher-yielding mortgage-backed securities, and a weakly-regulated Wall Street rushed to create new “product” to meet the demand (by lending to anyone with a pulse). At its peak, the resulting bubble took the median of the most reliable market valuation measures we follow to a level more than 95% above their historical norms, implying a prospective market loss on the order of -49% as that bubble collapsed.
While I've written about numerous valuation measures over time, the most reliable ones share a common feature: they focus on identifying "sufficient statistics" for the very, very long-term stream of cash flows that stocks can be expected to deliver into the hands of investors over time. On that front, revenues are typically more robust "sufficient statistics" than current or year-ahead earnings. See Exhaustion Gaps and the Fear of Missing Out for a table showing the relative reliability of a variety of measures. In April 2007, I estimated that an appropriate valuation for the S&P 500 stood about 850, roughly -40% lower than prevailing levels. By the October peak, the prospective market loss to normal valuation had increased to about -46%. As it happened, the subsequent collapse of the housing bubble took the S&P 500 about -55% lower. In late-October 1998, as the market plunge crossed below historically reliable valuation norms, I observed that the S&P 500 had become undervalued on our measures.
Again attempting to “stimulate” the economy from the recession that followed, the Federal Reserve cut short-term interest rates to zero in recent years, provoking yet another episode of yield-seeking speculation, where yield-starved investors created demand for virtually every class of securities, in the hope of achieving returns in excess of zero. Meanwhile, Wall Street, suffering from what J.K. Galbraith once called the “extreme brevity of the financial memory,” convinced itself yet again that the whole episode was built on something more solid than quotes on a screen and blotches of ink on paper. At last week’s highs, the median of the most reliable market valuation measures we follow reached an extreme that placed them 170% above their historical norms, implying a prospective market loss on the order of -63% in what I fully expect to be the collapse of the third speculative bubble since 2000. Notably, there is only a single week in history where the median valuation on our most reliable measures exceeded the level we just observed. That was the week of March 24, 2000, which set the peak of the tech bubble. Unlike the 2000-2002 retreat however, the damage to paper values over the completion of the current cycle is likely to spare few sectors, as the median valuation across individual stocks is at a record high, and far beyond the 2000 peak.
The chart below presents some of these valuation measures. Note that even if the completion of this cycle leaves these measures 25% above their historical norms, the resulting market decline would amount to about (1.25/2.70-1 =) -54%, while a decline that leaves valuations still 50% above their norms would still represent a market loss in excess of -44%. Aside from shorter-term bursts of speculative enthusiasm, even low interest rates are not likely to mitigate full-cycle market losses, because over time, the benefits of low rates are typically offset by the disappointing economic growth that produces them (see Rarified Air: Valuations and Subsequent Market Returns for a deep dive into these relationships). It’s important to be very clear on this point: a market loss between -44% and -63% over the completion of this cycle would not represent a worst-case scenario, but instead an ordinary, pedestrian, historically run-of-the-mill outcome given current valuation extremes.
While valuation measures are extremely informative about the prospects for market total returns on a 10-12 year horizon, as well as prospective market losses over the completion of any given market cycle, valuations are rather weak indicators of near-term market returns. Outcomes over shorter segments of the market cycle are much more dependent on the psychological inclination of investors toward speculation or risk-aversion, which we infer from the uniformity or divergence of market internals across a broad range of securities and markets (when investors are inclined toward speculation, they tend to be indiscriminate about it).
The central lesson of the recent advancing half-cycle, for us, was that in the presence of zero interest rates, even extreme “overvalued, overbought, overbullish” syndromes that had reliably warned of steep market losses in prior cycles were not enough; one had to wait for explicit deterioration in market internals before responding to hypervaluation with a hard-negative outlook. That will indeed be something to remember if the condition of market internals improves, and particularly if that occurs in the face of fresh zero-interest rate policy. But here and now, all of these measures present a hostile outlook. Dismissing present risks on the basis of my own stumble in the advancing half of this cycle is unlikely to be rewarding in the market wipeout that a century of history suggests will complete this cycle.