One of the interesting aspects of “bull markets” is the further they go, the lower forward returns fall. In hindsight, such an idea seems counter-intuitive, but ultimately it always comes down to valuations. As Warren Buffett once quipped: “Price is what you pay. Value is what you get.”
When markets are incredibly exuberant, as they are currently, it is not surprising that such is commonly associated with previous market peaks. The chart below shows the annual rate of change of the inflation-adjusted S&P 500 index from March to March. The recent market surge marks one of the largest on record. Such increases typically preceded corrections (10-20%) to outright bear markets.
As we will discuss momentarily, a look at GAAP valuations as a ratio to the “Volatility Index” also finds potential “Trouble in Paradise.”
However, despite these more basic understandings, investors still cling to the belief “this time is different.” To support that thesis, investors have pointed to low interest rates as support for excess valuations.