Valuations, Sufficient Statistics, and Breathtaking Risks

The financial markets create opportunities for both investment and speculation. It helps to have a sense of whether one, both, or neither of these opportunities are present.

Our own discipline makes a distinction between “investment merit” and “speculative merit,” reflecting observable market conditions at any point in time. On the “investment” front, valuations are the primary determinant of market outcomes on a 10-12 year horizon, and of potential downside risk over the completion of any given market cycle. Over shorter segments of the cycle, however, market outcomes are much more dependent on psychological factors. The difference between an overvalued market that becomes more overvalued, and an overvalued market that crashes, has little to do with the level of valuation and everything to do with investor preferences toward risk-seeking or risk-aversion. Those preferences can be largely inferred from the uniformity or divergence of observable market internals across a wide range of securities and asset classes (when investors are inclined to speculate, they tend to be indiscriminate about it).

For us, those distinctions proved to be extraordinarily valuable over every complete cycle prior to the half-cycle since 2009. But it’s worth briefly discussing our difficulty in the half-cycle since 2009 too, because understanding it may help investors to avoid the mistake of ignoring the breathtaking level of market risk they face here and now (detailed below). Those familiar with this discussion are still encouraged to read the next two paragraphs, because understanding this narrative matters so much here. For more detail, see A Better Lesson than "This Time is Different".

The problem in the period since 2009 was two-fold: First, the yield-seeking speculation encouraged by the Federal Reserve during the mortgage bubble led us to correctly anticipate the 2007-2009 collapse, but not the policy errors that ultimately brought the U.S. economy to the brink of another Depression. Policy makers ultimately papered over the problem by changing accounting rule FAS 157 in March 2009, and have since filled the hole in the banking system by depriving savers of interest, while encouraging even greater expansion of leveraged loans and low-grade covenant-lite debt. In hindsight, I made the error of insisting that our methods be robust to Depression-era data (though those efforts may prove valuable in future crises). In the interim, solving that “two data sets” problem led us to miss a recovery that neither our pre-2009 methods nor our current methods would have missed.

Second, the intentional encouragement of speculation by the Federal Reserve disrupted the historical tendency for extreme “overvalued, overbought, overbullish” syndromes to be closely followed by air-pockets, panics or crashes. Our reliance on those syndromes was our Achilles Heel. In the face of zero interest rates, one had to wait for market internals to deteriorate explicitly before adopting a hard negative outlook. We imposed that adaptation in 2014, which could have dramatically changed our experience in this period. Keep in mind that from the standpoint of compound returns, less than one-fifth of the S&P 500 total return in the half cycle since 2009 has been accrued since mid-2014.

[Geek’s Note: Given a cumulative gain of Y%, the proportion of the gain accounted for by X% is equal to ln(1+X)/ln(1+Y). So, for example, a 50% advance actually contributes half of a 125% cumulative gain, which should be clear from the fact that 1.5 x 1.5 = 2.25.]