There are certain features of valuation, investor psychology, and price behavior that emerge, to one degree or another, when the fear of missing out becomes particularly extreme and the focus of speculation becomes particularly narrow. We’ve suddenly hit a motherlode of those conditions. Emphatically, this is not a forecast. It's a statement about current, observable conditions.
Speculative psychology is the only thing standing between an hypervalued market that continues to advance and a hypervalued market that drops like a rock. Our best gauge of that psychology - the uniformity of market internals - remains divergent enough to keep market conditions in a trap-door situation.
The current perceptions of investors about their own "wealth" are out of line - to a historic extent - with the economic fundamentals that are available to support the claims.
There’s no question that persistently deranged and activist Federal Reserve policy has required investors to adapt. But the form of that adaptation is crucial. The thing that 'holds the stock market up' isn’t zero-interest liquidity, at least not in any mechanical way. It’s a particularly warped form of speculative psychology that rules out the possibility of loss, regardless of how extreme valuations have become.
A remarkable feature of extended bull markets is that investors come to believe that steep market losses are impossible. None has so thoroughly nurtured that illusion than the bubble we find ourselves in today.
When the time comes to ask the question – 'What triggered the crash?' – remember that this is the least important question. The important question to ask is 'What drove the bubble?' That's where the lessons are.
Equilibrium is like conservation of mass – every purchase is also a sale; every security that’s created must be held by someone until it is retired; the shortfall of one sector must be the surplus of another. Once you insist on thinking in terms of equilibrium, it becomes obvious how many discussions in economics and finance are incoherent.
Investors seem to be vastly underestimating the extent to which a likely economic rebound will replace rather than augment the effect of trillions of dollars in pandemic relief programs, amounting to close to 20% of GDP, which preserved corporate revenues while subsidizing labor costs.
When a good market valuation measure rises, the extra return you celebrate has simply been removed from the future. When a good market valuation measure collapses, the shortfall of return that you suffer has also been added to the future. It’s important to know where you stand in that cycle.
What defines a bubble is that investors drive valuations higher without simultaneously adjusting expectations for returns lower. That is, investors extrapolate past returns based on price behavior, even though those expectations are inconsistent with the returns that would equate price with discounted cash flows.