It is not to be forgotten that what we call rational grounds for our beliefs are often extremely irrational attempts to justify our instincts.
– Thomas Huxley

As we begin 2018, the most appropriate starting point is to clarify our actual investment stance. A central aspect of our outlook is the distinction between investment and speculation. If Wall Street believes that stock prices could advance further because investors temporarily have a speculative bit in their teeth, and that they care more that the environment “feels good” than about any careful evaluation of long-term investment prospects, we have no strenuous objection to that argument. Indeed, that’s exactly why, until we see more than the early deterioration in market internals we observe at present, our immediate investment outlook is rather neutral. On the other hand, if Wall Street believes that current valuations are actually “justified,” that 10-12 year S&P 500 total returns are likely to be meaningfully positive, or that the S&P 500 will avoid a collapse on the order of -65% over the completion of the current market cycle, my view is that these beliefs are strenuously at odds with the evidence from a century of market history.

The essential survival tactic for a hypervalued market, and its resolution ahead, is to recognize that market valuations can experience breathtaking departures from historical norms for extended segments of the market cycle, so long as shorter-term conditions contribute to speculative psychology rather than risk-averse psychology. One must distinguish between a boulder resting safely at a permanently high plateau, and a boulder teetering at the edge of a cliff, thanks to temporary and unreliable support. Refrain from imagining that extreme valuations are equivalent to “justified” or “durable” valuations. A century of evidence suggests that something very different is going on.

Specifically, while the most historically-reliable market valuation measures are now more than 2.8 times their historical norms, history has produced many instances (1929, 2000 and the present being the three most offensive) where stocks reached objectively extreme valuations on reliable measures, but prices continued to advance for a portion of the complete market cycle. The “hinge” that distinguishes an overvalued market that continues to advance from an overvalued market that drops like a rock is purely psychological – it’s the preference of investors toward speculation or risk-aversion, typically encouraged by short-term, cyclical factors that lead investors to feel optimistic or fearful. Based on a century of market evidence, we’ve found that the most reliable and observable measure of those psychological preferences is the uniformity or divergence of market internals across a broad range of individual stocks, industries, sectors, and security-types, including debt securities of varying creditworthiness. That uniformity is important, because when investors are inclined toward speculation, they tend to be indiscriminate about it.

The summary of our present outlook is this: we view market valuations as obscene, with negativeexpected S&P 500 total returns over the coming 10-12 year period, and a probable interim loss on the order of -65% over the completion of the current market cycle. Still, in the absence of further deterioration and dispersion in market internals, our immediate market outlook is actually rather neutral. Remember also that a material retreat in valuations, coupled with an early improvement in market internals, is likely to produce favorable investment opportunities far sooner than 10-12 years from now.

Presently, a further deterioration in market internals, particularly evidenced by widening credit spreads or expanding breakdowns among individual stocks, would signal a shift in investor preferences from speculation toward risk-aversion. We’ll take that evidence as it emerges. I do believe that out-of-the-money tail-risk hedges may be useful, given the low level of option volatility (as measured by the VIX), but a negative market outlook should wait on further internal deterioration. Establishing tail-risk hedges may be useful because, as investors discovered after the 1929, 1973, 1987, 2000 and 2007 peaks, once internals deteriorate materially, the exit doors can prove to be impossibly narrow, at a point where the distance between prices and historically reasonable valuations remains very wide.

Put simply, valuation is the essential driver of investment returns over a 10-12 year horizon, and of the potential market loss over the completion of any given cycle. However, market returns over shorter segments of the cycle (as well as deviations from value-based expectations) are mainly driven by cyclical fluctuations in investor psychology. Even the most extreme overvaluation has little effect on market direction in periods when investors feel optimistic. Likewise, even deep undervaluation may provide little support in periods when investors are fearful. The key during these times is to refrain from attempts to “justify” the level of prices just because the market is trading at one extreme or another, and to carefully monitor the uniformity or dispersion of market internals, in order to gauge that psychology in an observable way.