Two Supports, Already Kicked Away
With no material change to our investment outlook, I’ll keep this comment brief. On the basis of the most reliable valuation measures we identify (those most tightly correlated with actual subsequent 10-12 year S&P 500 total returns), current market valuations stand about 140-165% above historical norms. No market cycle in history, even those prior to the mid-1960s when interest rates were similarly low, has failed bring valuations within 25% of these norms, or lower, over the completion of the market cycle. On a 12-year horizon, we project likely S&P 500 nominal total returns averaging close to zero, with the likelihood of an interim market loss on the order of 50-60% over the completion of the current cycle.
As I’ve observed for decades, even a richly overvalued market can move higher, provided that investors remain inclined to speculate, which we infer from the uniformity of market action across a broad range of market internals (when investors are inclined to speculate, they tend to be indiscriminate about it). In prior market cycles across history, however, even favorable market internals were overruled once extreme “overvalued, overbought, overbullish” syndromes emerged. The half-cycle since 2009 was different. In the face of zero interest rates, yield-seeking speculation persisted even after those extreme syndromes emerged. The best indication of that speculative mindset is that market internals remained uniformly favorable during most of the period prior to mid-2014. Importantly, even since 2009, the S&P 500 has lost ground, on average, in periods when extreme overvalued, overbought, overbullish syndromes were accompanied by deteriorating market internals. That’s the situation we observe at present.
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. From here, we expect the dynamics of this market cycle to resemble other periods when offensive valuations and extreme overvalued, overbought, overbullish syndromes were joined by deteriorating market internals (particularly when interest rates were off their lows). Short term market outcomes are anybody’s guess, but across history, that overall combination has typically defined crash dynamics.
Notably, we’ve observed a widening of internal dispersion in recent weeks. For example, weekly NYSE new lows have averaged about 4% of traded issues recently, with nearly 6% last week, even with the S&P 500 near record highs. Meanwhile, nearly 40% of stocks are already below their 200-day averages. I’ve noted before that raw “Hindenburg Omens” (days when both NYSE new highs and new lows exceed about 2.5% of traded issues) are typically not ominous at all. The exception is where they are accompanied by a broader syndrome of tepid market breadth even with the major indices still elevated, when multiple signals appear in close succession, and when market internals are unfavorable on our own measures. On that note, we’ve observed 4 such daily signals in recent weeks, with two last week alone. We saw similar widening of internal dispersion in December 1999, July and November 2007, and July-August 2015. Still there are a few signals such as 2006 and 2013 that were followed by only minor hiccups. That improves the average outcome, though the average is still negative overall.
Overall, our current market outlook remains strongly negative, but we would be inclined to adopt a more neutral outlook if our measures of market internals were to improve. As I’ve often observed, the most favorable market return/risk profile we identify typically emerges when a material retreat in valuations is joined by an early improvement in market action. Whether that occurs after a moderate correction, or after a market collapse, that’s the combination most likely to move us to a constructive or aggressive outlook, depending on the status of valuations and other conditions at that point. The most extreme overextended syndromes we identify are now accompanied by deteriorating market internals and interest rates that are well off the zero bound. My impression is that without a shift back to uniformly favorable market internals, the continued faith in monetary support may prove to be the same awful bet it was during the 2000-2002 and 2007-2009 collapses, both which were accompanied by aggressive monetary easing all the way down.
We’ll take our evidence as it arrives.