In recent decades, there have been points where stocks were steeply overvalued (as I observed in 2000, 2007, and of course, in recent years), clearly undervalued (as I observed in 1990 and late-2008), and neutral enough to adopt a constructive outlook based on improved market internals (as I observed in early-2003). Regardless of the situation, I’ve always emphasized a key fact: valuations have a profound impact on 10-12 year market returns, and on potential losses over the completion of any market cycle, but have little impact on market outcomes over shorter segments of the market cycle.

This has clearly been true in recent years. A moment’s thought should make it obvious that the stock market was only able to reach extremes like those of 1929, 2000, and today because valuations failed, for some portion of the market cycle, to collapse from less extreme levels. So while valuations haven’t “worked” in recent years, as is often the case during speculative periods, there’s nothing in recent market behavior to suggest that the relationship between valuations and subsequent full-cycle market returns has changed at all. Investors who believe that valuations have somehow become irrelevant because they haven’t “worked” in recent years simply don’t understand how valuations actually work.

Before discussing the profile of risks facing investors at present, it will help to quickly review the central considerations of our investment discipline.

While valuations are the main drivers of long-term, full-cycle market outcomes, they often say very little about market outcomes over periods substantially shorter than 10-12 years. On shorter horizons, investor psychology matters more. How does one measure that? I’ve frequently emphasized that when investors are inclined to speculate, they tend to be indiscriminate about it. So the uniformity or divergence of market internals across a broad range of securities tells us a great deal about whether investors are inclined toward speculation or risk-aversion. Indeed, the condition of market internals (what I used to call “trend uniformity”) is the main feature that distinguishes an overvalued market that moves higher from an overvalued market that drops like a rock.

In our own methods, we extract a signal about speculation or risk-aversion from the uniformity or divergence of market action across thousands of individual securities, sectors, industries, and security-types, including debt securities of varying creditworthiness. We don’t publish those methods, but suffice it to say that when the market demonstrates divergences and breakdowns in the behavior of various sectors, that loss of “uniformity” is often a signal that investor preferences have subtly shifted toward risk-aversion. Conversely, we find that the most favorable market return/risk profiles typically emerge at the point where a material retreat in valuations is joined by an early improvement in market internals.