Broadening Internal Dispersion

Nothing in history leads me to expect that current extremes will end in something other than profound disappointment for investors. In my view, the S&P 500 will likely complete the current cycle at an index level that has only 3-digits. Indeed, a market decline of -63% would presently be required to take the most historically reliable valuation measures we identify to the same norms that they have revisited or breached during the completion of nearly every market cycle in history.

The notion that elevated valuations are “justified” by low interest rates requires the assumption that future cash flows and growth rates are held constant. But any investor familiar with discounted cash flow valuation should recognize that if interest rates are lower because expected growth is also lower, the prospective return on the investment falls without any need for a valuation premium.

This is not just a theoretical matter. Across history, the impact of variations in interest rates and growth rates systematically wash each other out, which is why long-term returns are so tightly linked to starting valuations (see Rarefied Air: Valuations and Subsequent Market Returns for a full exposition). With regard to future economic growth prospects, the fact is that demographic factors constrain likely U.S. labor force growth to just 0.3% annually in the coming years, while U.S. productivity growth has declined from 2% annually in the post-war period, to 1% annually over the past decade, and just 0.6% annually over the past 5 years. Add 0.3% and 0.6%, and the baseline expectation for U.S. economic growth in the coming years is just 0.9% annually, assuming that the unemployment rate does not rise at all from the current level of 4.3%. As I detailed in Stalling Engines: The Outlook for U.S. Economic Growth, even a future 1.85% trajectory for U.S. real GDP growth requires that some combination of labor force growth and productivity growth will accelerate from the current baseline.

Given that real U.S. GDP growth has averaged just 2.2% over the past 4 years, and that the current starting positions of labor force growth, unemployment, and the trade balance suggest a deceleration even from that average, we shouldn’t be surprised if real U.S. GDP growth amounts to just a fraction of a percent annually over the coming 4-year period.

Valuations, market action, and overextended syndromes

It’s important to observe that if short-term interest rates were still at zero and market internals were favorable, even the most extreme overvalued, overbought, overbullish syndromes we identify would not be enough to push us to a hard-negative market outlook. That, in a nutshell, is the central lesson from quantitative easing, and is one that could alone have dramatically altered our own challenging experience in the recent speculative half-cycle.

At present, however, we observe not only the most obscene level of valuation in history aside from the single week of the March 24, 2000 market peak; not only the most extreme median valuations across individual S&P 500 component stocks in history; not only the most extreme overvalued, overbought, overbullish syndromes we define; but also interest rates that are off the zero-bound, and a key feature that has historically been the hinge between overvalued markets that continue higher and overvalued markets that collapse: widening divergences in internal market action across a broad range of stocks and security types, signaling growing risk-aversion among investors, at valuation levels that provide no cushion against severe losses.

We extract signals about the preferences of investors toward speculation or risk-aversion based on the joint and sometimes subtle behavior of numerous markets and securities, so our inferences don't map to any short list of indicators. Still, internal dispersion is becoming apparent in measures that are increasingly obvious. For example, a growing proportion of individual stocks falling below their respective 200-day moving averages; widening divergences in leadership (as measured by the proportion of individual issues setting both new highs and new lows); widening dispersion across industry groups and sectors, for example, transportation versus industrial stocks, small-cap stocks versus large-cap stocks; and fresh divergences in the behavior of credit-sensitive junk debt versus debt securities of higher quality. All of this dispersion suggests that risk-aversion is rising, no longer subtly. Across history, this sort of shift in investor preferences, coupled with extreme overvalued, overbought, overbullish conditions, has been the hallmark of major peaks and subsequent market collapses.