It’s sometimes said that “risk happens fast.” Yet underlying financial damage often has a long and quiet incubation phase, which is why Hemingway described bankruptcy as occurring “gradually and then suddenly.”
The Federal Reserve has performed an amygdalotomy on the investing public, encouraging a maladaptive confidence that risk does not exist. A similar response early in the COVID-19 epidemic also contributed to profound losses of both human life and economic activity.
Containing this epidemic, and containing this economic downturn, both require a clear understanding of how the infection is transmitted, and how to blunt its impact.
There’s no need to worry about various scenarios, to project targets, to predict market movements, or to become tied to any particular forecast about future economic or financial events. This is not about prediction, and projection, and forecasting. What's needed is the ability and willingness to flexibly respond to changes in observable market conditions as they emerge.
Presently, we continue to observe extreme valuations, coupled with ragged and divergent market internals. Yet we also observe very compressed short-term market action that has historically been permissive of “fast, furious” clearing rallies to relieve that compression. We are not “bullish” from a full-cycle perspective, and we continue to view safety nets as essential, but this compression does encourage us to have a more “two-sided” view about very near-term volatility.
The menu of investment choices for passive, long-term investors is now the worst in history. When speculation drives prices to hypervalued extremes and likely risk-premiums to zero - or worse - investors face an additional problem. A market crash is simply a low risk-premium spiking higher. That's not hyperbole, and it's not a market call. It's just a fact.
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.