Eternal Sunshine of the Spotless Mind

"Like bubbles on the sea of matter borne,
they rise, they break, and to that sea return."
– Alexander Pope

Last week, the stock market recorded the most offensive valuation extreme in history, on the basis of measures best correlated with actual subsequent returns across a century of market cycles. The advance brought the S&P 500 Index about 1% above its previous January 26 record. The current extreme eclipses both the 1929 peak, and the 2000 bubble peak.

I am aware of no plausible conditions under which current extremes are likely to work out well for investors. There are a few possibilities that could involve a smaller loss than the two-thirds of market capitalization that I expect to vanish, as the run-of-the-mill, baseline expectation for the S&P 500 over the completion of this cycle. Yet it’s worth recognizing that the completion of every market cycle in history has taken the most reliable valuation measures we identify (those best correlated with actual subsequent S&P 500 market returns) to less than half of current levels.

Still, be careful about what you do with information about valuations. If overvaluation was sufficient to halt a market advance, we would never have observed valuations like 1929, 2000, and today, because those advances would have ended at lesser extremes. It’s common to imagine that if valuations have pushed to extreme levels without a collapse, there must be something wrong with the valuation measures. But that’s not how valuations work.

The central fact of full-cycle investing is that when investors have the speculative bit in their teeth, valuations can mean very little for extended segments of the market cycle. In our own discipline, we infer that psychological inclination of investors from the uniformity or divergence of market action across thousands of securities, including debt securities of varying creditworthiness. We don’t disclose our own measures of market internals, but the key idea is that when investors are inclined to speculate, they tend to be indiscriminate about it. In contrast, when speculation becomes increasingly selective and narrow, it suggests growing risk-aversion among investors. That’s when extreme valuations suddenly become important, and the market becomes vulnerable to collapse.

Historically, when trend uniformity has been positive, stocks have generally ignored overvaluation, no matter how extreme. When the market loses that uniformity, valuations often matter suddenly and with a vengeance. This is a lesson best learned before a crash rather than after one.
– John P. Hussman, Ph.D., October 3, 2000