We estimate that current market conditions now “cluster” among the worst 0.1% instances in history – more similar to major market peaks and dissimilar to major market lows than 99.9% of all post-war periods.
The S&P 500 is two years into what we expect to be a very long, interesting trip to nowhere. The strongest stock market returns in the coming decade, perhaps longer, are likely to emerge during advances in the S&P 500 that attempt to catch up with the cumulative return of risk-free Treasury bills. Recall that investors experienced the same outcome between 1929-1947, 1968-1985, and 2000-2013.
The yearning affection that investors hold for Fed pivots is quietly driven by the fact that nearly all the pivots occurred when the S&P 500 already stood at historically normal or depressed levels of valuation. The associated market returns were typically a function of two factors: favorable valuations, coupled with an improvement in market internals. It’s those factors – the central elements of our investment discipline – that actually correlate with favorable market outcomes.
In every noise-reduction problem, uniformity matters. There is vastly more information in the common signal drawn from multiple sensors than there is in any single measure by itself. While we still don’t have enough data to anticipate a recession with high confidence, my view is that the sudden enthusiasm about a 'soft landing' runs exactly opposite to the trend of the data.
The recent 'everything bubble' has taken its dear sweet time to collapse. Even though the S&P 500 remains down from its early 2022 peak, and 30-year Treasury bonds have lost over half their value since early 2020, the market has maintained the appearance of 'resilience.' Yet there need not be a proportional relationship between the size of the last grain of sand, the length of the last straw, or the weight of the landing butterfly, and the extent of the catastrophe they provoke.
Fed policy variables provide very little information about subsequent economic outcomes over-and-above the information available from non-monetary variables alone. The exception is economic crisis that inevitably follows interest rate suppression, yield-seeking speculation, and misalignment of monetary and economic quantities. 'The crisis takes a much longer time coming than you think,' said the late MIT economist Rudiger Dornbusch, 'and then it happens much faster than you would have thought.'
There is a particular 'setup' that we’ve historically found to be associated with abrupt 'air pockets' and 'free falls' in the S&P 500. It combines hostile conditions in all three features most central to our investment discipline: rich valuations, unfavorable market internals, and extreme overextension. The potential for this sort of event isn’t a forecast so much as a regularity that should not be ruled out.
My impression is that the current market advance is a narrow and selective speculative blowoff - a bear market rally driven by fear of missing out on the resumption of a bubble that is actually in the early stage of collapse - and that the equity market is likely to suffer profound losses over the completion of the full market cycle.
The greater the misalignment between financial quantities and economic quantities, the more distorted and grotesque the whole picture becomes, particularly if nobody carefully connects the dots. Unfortunately, investors and policy makers repeatedly insist on learning that the hard way.
Departures from systematic monetary policy distort behavior in ways that cause misalignments between financial quantities and real economic quantities, and as a result, they invariably produce damage as the two are ultimately realigned.