"Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces."
– Sigmund Freud

At present, the valuation measures that we find best correlated with actual subsequent S&P 500 total returns are at the most offensive levels in history, matching or eclipsing the 1929 and 2000 extremes. Even considering the level of interest rates, economic growth, and other factors, the S&P 500 currently stands about 2.8 times the level that we believe the index will revisit over the completion of the current market cycle, implying an interim market loss something on the order of -64%. Moreover, the most reliable valuation measures uniformly imply the likelihood of negative total returns in the S&P 500 over the coming 10-12 year period.

I’m not saying that Wall Street is misguided to believe that stocks are appropriately priced here. I’m saying that Wall Street is spectacularly misguided in that belief. The main factor with the capacity to support stock prices here is the psychological inclination of investors to speculate. When investors are inclined to speculate, they tend to be indiscriminate about it. So the best evidence of those speculative inclinations is the uniformity or divergence of market action across a broad range of individual stocks, industries, sectors, and security-types, including debt securities of varying creditworthiness. With our measures of market internals deteriorating in recent weeks, even that factor is sputtering (see the November 13 interim update, Distinctions Matter – join our News List to have these special updates delivered to your inbox).

Despite the late-November advance in the major indices, the condition of market internals remains unfavorable on our measures. Still, we’re holding to a fairly neutral near-term outlook, rather than a hard-negative one. Given the extent of current overvaluation, it’s enough to keep more aggressive safety nets and tail-risk hedges several percent below current levels, and it’s essential to be flexible in the intensity of our concerns. The primary consideration for investors is to adapt in a way that neither fights against the speculation, nor leaves investors relying on a “permanently high plateau.”

At present, low interest rates neither justify nor mitigate the extreme valuations of the U.S. equity market. To the contrary, low interest rates simply add insult to injury, joining poor total return prospects for stocks with similarly poor total return prospects for fixed income. The chart below presents our estimate of prospective 12-year annual total returns for a conventional portfolio mix invested 60% in the S&P 500, 30% in Treasury bonds, and 10% in Treasury bills (blue line). The red line shows the actual total returns for this portfolio mix over the subsequent 12-year period. Presently, passive investors face the most dismal total return prospects in U.S. history.

This doesn’t mean that the coming years will be without opportunity. Investors with more flexible disciplines should observe that across history, market collapses have produced upward spikes in expected returns, so we certainly expect investors to encounter strong investment opportunities even in the next few years. As usual, we expect the strongest opportunities to emerge when a material retreat in valuations is joined by an early improvement in market action.