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.
Nothing so animates a speculative herd as a parabolic price advance in an asset detached from any standard of value.
The present constellation of market conditions creates the potential for the sort of “trap door” situation we observed in March. Still, an improvement in our measures of market internals would ease this risk, and could even create a constructive opportunity if improved market internals are first preceded by a material retreat in market valuations.
When people say that extreme stock market valuations are “justified” by interest rates, what they’re actually saying is that it’s “reasonable” for investors to price the stock market for long-term returns of nearly zero, because bonds are also priced for long-term returns of nearly zero. I know that’s not what you hear, but it’s precisely what’s being said.
Investors have apparently decided that if they’re going to price bonds at levels that provide long-term returns of next-to-nothing, they might as well go ahead and price everything that way.
Comments on what is now the most profoundly overvalued financial bubble in U.S. history, with additional notes on governance and public health.
Herd mentality poses a danger at every turn here. While Wall Street seems excited about the possibility that the Federal Reserve may eventually drive rates to negative levels, passive investors should recognize that the Fed has already engineered negative rates – for the first time in U.S. history, including the 1929 top. Unfortunately, it’s in their portfolio, and they don’t realize it. Also: notes on public health, herd immunity, and containing COVID-19.
The most important observation about market valuations here is that while a decade of zero interest rate policy has encouraged yield-seeking speculation in stocks, the resulting extreme in stock market valuations has also driven likely 10-12 year S&P 500 nominal total returns below zero. Investors are not likely to find an alternative to hypervalued stocks and bonds in some undiscovered asset that they can passively hold instead. The alternative is patient, value-conscious discipline, flexible to changes in valuations, market internals, and other factors.
The way to create a second wave of an epidemic is to relax containment practices while there is still a large pool of active, infective cases. In the financial markets, the immediate outlook remains negative, but we remain sensitive to any change in the uniformity of market internals.