Put simply, with market internals unfavorable and interest rates off the zero bound, the two main supports that made the half-cycle since 2009 “different” have already been kicked away.
The Fed does not have to make guesses about exactly what is required to normalize its balance sheet, except to the extent that it ignores a century of evidence.
The characteristic feature of a bubble is that the long-term return implied by discounted cash flows becomes detached from the higher, temporarily self-reinforcing return that is imagined by investors. As a result, the bubble component accounts for an increasingly large proportion of the total price, and becomes progressively vulnerable to collapse. It is in this precise sense that the current speculative episode can be characterized as a bubble, just as I (and Modigliani) characterized the bubble that ended in 2000.
Overall, my impression remains that the market is in the process of tracing out the blowoff finale of the third speculative financial bubble since 2000. Still, as is true for the market cycle as a whole, the broad outline of this top formation is likely to be shaped by three factors: 1) valuations, which primarily affect total market returns over a 10-12 year horizon, as well as the magnitude of potential losses over the completion of the market cycle; 2) the uniformity or divergence of market internals across a broad range of stocks and security-types, which remains the most reliable measure we’ve identified of the psychological preference of investors toward speculation or risk-aversion (when investors are inclined to speculate, they tend to be indiscriminate about it); and 3) overextended market action highlighting extremes of speculation or fear - in the advancing portion of the market cycle, these are best identified by syndromes of overvalued, overbought, overbullish conditions.
It’s precisely the failure of valuations to matter over shorter segments of the market cycle that regularly convinces investors that valuations don’t matter at all
My friend Mark Hulbert once had a philosophy professor at Oxford, who distinguished two ways of being wrong: “You can be just plain wrong, or you can be wrong in an interesting way.” In the latter case, Mark explained, correcting the wrong reveals a lot about the underlying truth.
When investors pay high P/E multiples on earnings that already reflect cyclically-elevated profit margins, they pay twice for their investment.
Every episode in history has its own wrinkles. But investors should not use some “new era” argument to dismiss the central principles of investing, as a substitute for carefully quantifying the impact of those wrinkles. Unfortunately, because investors get caught up in concepts, they come to a point in every speculative episode where they ignore the central principles of investing altogether.
Despite extreme valuations, investors’ fear of missing out is looking increasingly desperate. In market cycles across history, that has been an unfortunate impulse.
One way to use information on stock valuations and interest rates in a systematic way is to estimate the break-even level of valuation that would have to exist at given points in the future, in order for stocks to outperform or underperform bonds over various horizons. Investors presently face a dismal menu of expected returns regardless of their choice. Indeed, in order for expected S&P 500 total returns to outperform even the lowly return on Treasury bonds in the years ahead, investors now require market valuations to remain above historical norms for the next 22 years.The good news is that this menu is likely to improve substantially over the completion of the current market cycle. The problem is that current valuation extremes present a hostile combination of weak prospective return and steep risk.