The problem with speculation is that there’s usually a gap between the underlying risk and the inevitable outcome. The gap is most dangerous when there are potential rewards for pushing your luck.
Whether we examine the projections of Wall Street analysts, or the pricing behavior of options traders, investors seem to have ruled out tail-risk - the risk of extreme market losses. Both of have historically behaved as contrary indicators.
Year-to-date market losses have retraced the frothiest segment of the recent speculative bubble, yet our estimates of prospective returns for a passive 60% S&P 500, 30% Treasury bond, 10% T-bill portfolio are nowhere near levels that we would associate with satisfactory long-term returns. Presently, market conditions reflect neither what we would consider "investment merit" nor "speculative merit."
Valuations are the “weighing machine” and provide information about likely long-term investment returns and the potential extent of market losses over the completion of any market cycle. Market internals are the “voting machine” and provide information about speculative versus risk-averse investor psychology. Presently, both the weighing machine and the voting machine point in the same direction. That will change. Until it does, ignoring them is a mistake.
Value is not measured by how far prices have declined, but by the relationship between prices and properly discounted cash flows. When the cash flows are very long-term in nature, and the deviation from median historical valuations is extreme, simply attaining those run-of-the-mill valuation norms can imply seemingly preposterous losses. Then the market suffers seemingly preposterous losses anyway.
There’s no question that Fed-induced speculation encouraged investors to chase extreme valuations, and to accept low returns on every class of investments. Unfortunately, Fed policy does not change the arithmetic that links valuations with subsequent returns. By our estimates, the S&P 500 is likely to lag Treasury bonds, and even Treasury bills, for more than a decade. Now comes the hard part.
What drives investment returns? Can you simply buy stocks at any price and assume you'll enjoy long-term returns on the order of 10% annually? The answer is no. Unfortunately, the financial industry often encourages investors to imagine this is how markets work. Is there some meaningful structure that drives returns? The answer is yes. Understanding it offers clear insights about how we got here, and where we may be going.
Lao Tzu wrote, “A journey of a thousand miles begins with a single step.” In recent months, the financial markets have taken the first step toward normalization. Unfortunately, having taken one step, the most prominent question we hear is “Are we there yet?!?"
Despite the year-to-date decline in the S&P 500, the most reliable valuation measures we monitor remain at levels never observed in market history prior to August 2020. Meanwhile, market internals remain ragged and divergent, suggesting risk-aversion among investors. That combination creates what I've often described as a "trap door" situation. You make friends with bears by understanding them, and by avoiding behavior that will get you eaten.
The most challenging financial event for investors in the coming decade will be the repricing of securities to valuations that imply adequate long-term returns, following more than a decade of reckless and intentional Fed-induced yield-seeking speculation.