The Structural Drivers of Investment Returns

This is the longest period of practically uninterrupted rise in security prices in our history… The psychological illusion upon which it is based, though not essentially new, has been stronger and more widespread than has ever been the case in this country in the past. This illusion is summed up in the phrase ‘the new era.’ The phrase itself is not new. Every period of speculation rediscovers it… During every preceding period of stock speculation and subsequent collapse business conditions have been discussed in the same unrealistic fashion as in recent years. There has been the same widespread idea that in some miraculous way, endlessly elaborated but never actually defined, the fundamental conditions and requirements of progress and prosperity have changed, that old economic principles have been abrogated… that business profits are destined to grow faster and without limit, and that the expansion of credit can have no end.

– The Business Week, November 2, 1929

After more than 40 years of work in the financial markets, studying all the data I could get my hands on, I’ve found it to be universally true that those who argue “history doesn’t matter” have never actually studied history.

While the value-conscious, historically-informed, full-cycle discipline that emerged from that research helped to admirably navigate decades of market cycles prior to the Federal Reserve’s deranged foray into zero-interest rate policy, I’ll note right up front that the stupidest thing I’ve ever done was to rely on historical “limits” to stupidity. Easy money does nothing to support the market when investor psychology is risk-averse, as investors should recall from the 2000-2002 and 2007-2009 collapses, but it’s a remarkable amplifier of speculation if investors have psychologically ruled out the possibility of price losses – getting a yield greater than zero becomes the only thing that matters. Faced with zero interest rates, yield-seeking investors continued speculating past every historically-reliable “limit.”

We’ve adapted in recent years, becoming content to align our outlook with prevailing market conditions – mainly valuations and market internals, which are our best gauge of speculative versus risk-averse investor psychology – without assuming “limits” to either. When investors are inclined to speculate, they tend to be indiscriminate about it. I constructed our gauge of market internals in 1998, with minor adaptations since, to measure the “uniformity” of market action across thousands of individual stocks, industries, sectors, and security-types, including debt securities of varying creditworthiness. Internals remain unfavorable here, valuations remain historically extreme, and interest rates are no longer at zero, but we’ll still defer our bearish outlook if uniform market internals indicate that investors have taken the speculative bit back in their teeth.