The more glorious this bubble becomes in hindsight, the more dismal future investment returns become in foresight. Investment is not independent of price. As Graham & Dodd observed, "Had the same attitude been taken by the purchaser of common stocks in 1928-1929, the term ‘investment’ would not have been the tragic misnomer that it was."
One of the striking things about bull markets is that they often end in confident exuberance, while simultaneously deteriorating from the inside. Internal divergences, the lowest prospective market returns in U.S. history, and why not-QE really is not QE.
Last week, our estimate of prospective 12-year nominal annual total returns on a conventional portfolio mix (invested 60% in the S&P 500, 30% in Treasury bonds, and 10% in Treasury bills) fell to the lowest level in U.S. history, plunging below the level previously set at the peak of the 1929 market bubble. Yes, interest rates are low, but with them, so are the discount rates and long-term returns embedded into prices.
We identify phase transitions by looking for a gestalt – several features that form a coherent, recognizable whole - in this case reflecting dispersion in leadership (new highs vs new lows), participation (the % of individual stocks joining a given market advance), and breadth (advancing vs declining issues) emerging immediately near a record market high.
If a high-risk market peak were a duck, observable market conditions presently include a striking collection of duck-like features. The key idea here isn't terribly complex. High-risk market conditions feature the simultaneous appearance of market extremes and market divergences; essentially an overextended market losing its engines.
As the financial markets enter what I expect to be a rather disruptive completion to the recent speculative half-cycle, it will be helpful for investors to consider certain propositions that are readily available from history, rather than insisting on re-learning them the hard way.
At extreme valuations, it’s important to remember that the completion of a hypervalued market cycle can wipe out every bit of the stock market's total return over-and-above T-bills, going back not just a few years, but for over a decade. In my view, investors are on the cusp of yet another very long period in which the stock market is likely to go “nowhere in an interesting way.”
Quantitative easing is simply an asset swap. QE doesn’t produce inflation, and whatever inflation we get will not be the result of QE. What inflation requires is public revulsion to government liabilities, and what produces public revulsion is the creation of government liabilities at a rate that destabilizes the expectation that those liabilities remain sound.
While investors appear exuberant about the prospect for Fed easing, they seem largely unaware that initial Fed easings have almost invariably been associated with U.S. recessions. They’re running toward the fire. Meanwhile, we presently observe market conditions that have been associated almost exclusively, and in most cases precisely, with the most extreme bull market peaks across history.
With the exception of 1967 and 1996, every initial easing of monetary policy by the Federal Reserve has been associated with an oncoming or ongoing recession. Investors should recognize that there is a certain amount of information content in those initial rate cuts. Specifically, when the Federal Reserve shifts from tightening (or normalizing) monetary policy and instead begins a fresh round of rate cuts, it's a clear indication that something in the economy has gone wrong. Moreover, the historical evidence is very clear that when investor psychology shifts from speculation to risk-aversion, even persistent and aggressive Federal Reserve easing does nothing to support stocks.