Brief Observations: Distinctions Matter

Brief Observations

Last week, the uniformity of market internals shifted to an unfavorable condition. This classification is based on current, observable market conditions. Historically, our measures of internals have shifted about twice a year, on average. We can’t rule out a fresh shift back to more favorable conditions, or a resumption of speculative pressures, but we’ll take that evidence as it arrives. While our immediate market outlook has been rather neutral in recent months, the combination of offensive valuations, extreme “overvalued, overbought, overbullish” conditions, and unfavorable market internals shifts us back to a negative market outlook. Still, the potential downside risk of the market over the completion of this cycle is so deep that it’s probably sufficient to maintain tail-risk hedges and index put option strike prices a few percent below current market levels.

Our primary measures of market internals reflect the behavior of broad range of individual stocks, industries, sectors, and security types, including debt securities of varying creditworthiness. We would characterize last week’s shift as “early deterioration” because the key feature isn’t the depth of the weakness, but instead the uniformity of that deterioration (which has historically been more important). This deterioration can also be observed in a variety of standard measures, including the recent spike in junk bond yields, three consecutive weeks of negative market breadth and negative net volume (advancing volume minus declining volume), weak participation featuring more than 40% of U.S. stocks falling below their respective 200-day averages, and internal dispersion featuring numerous stocks hitting both 52-week highs and 52-week lows despite record highs in the major indices.

Because robust speculation tends to be rather indiscriminate, we view deterioration in the uniformity of market internals as a reflection of a subtle shift toward risk-aversion among investors. In hypervalued markets characterized by extreme “overvalued, overbought, overbullish” conditions, these shifts are often associated with steep market losses.

Distinctions matter

I continue to observe a great deal of misunderstanding around our investment approach. It’s best to clarify this confusion before it’s too late. Our challenge in the advancing half-cycle since 2009 was that we relied too heavily “overvalued, overbought, overbullish” features of market action. Though we fully anticipated the market collapse of 2007-2009, the resulting credit strains and employment losses were wholly outside of post-war experience, which prompted my insistence on stress-testing our methods against Depression-era data. One of the features of the resulting classification methods was that they prioritized “overvalued, overbought, overbullish” syndromes ahead of our measures of market internals, because of their reliability in prior cycles across history.

This cycle has been “different” in the sense that zero interest rate policy, as well as post-election enthusiasm, has encouraged continued speculation despite the most extreme “overvalued, overbought, overbullish” syndromes on record. Nearly all of the adaptations we’ve introduced to our approach in recent years have been to restore the pre-2009 priority we placed on the uniformity of market internals. That process was painfully incremental, and it’s admittedly small comfort that we were being good Bayesians (updating our “priors” in the face of outcomes that conflicted with information from a century of prior market cycles). Still, those who imagine that our key valuation measures have become less reliable, or that we are ignoring “technical” factors, or monetary factors, or price behavior here simply misunderstand the actual issue that we needed to address.