We extract signals about the preferences of investors toward speculation or risk-aversion based on the joint and sometimes subtle behavior of numerous markets and securities, so our inferences don't map to any short list of indicators. Still, internal dispersion is becoming apparent in measures that are increasingly obvious.
In my view (supported by a century of market cycles), investors are vastly underestimating the prospects for market losses over the completion of this cycle, are overestimating the availability of “safe” stocks or sectors that might avoid the damage, and are overestimating both the likelihood and the need for some recognizable “catalyst” to emerge before severe market losses unfold.
At the height of the technology bubble, the median of the most reliable market valuation measures we follow (those most strongly correlated with actual subsequent S&P 500 total returns) briefly reached an apex 178% above historical norms that had been regularly approached or breached over the completion of every market cycle in history.
Last week, the S&P 500 price/revenue ratio reached the highest level in history, outside of the single week of March 24, 2000 that represented the peak of the tech bubble.
What’s often missed in the “low interest rates justify higher valuations” argument is that this proposition assumes that future cash flows and growth rates are held constant.
Fully 1.4% of the 2.0% average annual real GDP growth observed since the beginning of 2010 has been driven by growth in civilian employment. As slack labor capacity has slowly been reduced, the unemployment rate has dropped from 10% to just 4.4%. That jig is up.
We are at the far edge of a monumental mesa here, but speculators are ignoring the cliff, assuming that they are on a permanently high plateau. The unfortunate aspect of these mesas and valleys is that they encourage backward-looking investors to believe that projected returns based on “old valuation measures” are no longer relevant, precisely when valuations are most informative about future returns.
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.