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“Traditional Measures Of Stock Valuation Have Become Obsolete” – 1920s, 1990s, & 2020

Courtesy of ZeroHedge View original post here.

Excerpted from John Hussman's Weekly Market Comment,

"The most striking similarity between the 1920s and 1990s bull markets is the notion that traditional measures of stock valuation had become obsolete."

– Edward Chancellor, Devil Take The Hindmost

You know it’s a bubble when you have to edit the Y axis on all of your charts because valuations have broken above every historical peak, and estimated future market returns have fallen beyond the lowest points in history, including 1929.

One of the things to remember about investing is that the higher the price you pay today, for a given stream of future cash flows, the lower the long-term returns you can expect. It’s exactly when past returns are most glorious that future prospects are most dismal.

Still, it’s also clear that if overvaluation alone was enough to drive prices lower, the market could never reach the sort of extreme hypervaluation we saw in 1929 and 2000, nor the dismal long-term prospects those valuations created.

So we have to distinguish between long-term returns, which are driven by valuations, and returns over shorter segments of the market cycle, which are driven by investor psychology.

When investors are inclined toward speculation, they tend to be indiscriminate about it. In market cycles across history (including the most recent one), we’ve find that the most reliable gauge of whether investors are inclined toward “speculation” or “risk-aversion” is the uniformity of market internals across thousands of stocks, industries, sectors, and security-types, including debt securities of varying creditworthiness.

It’s worth repeating that the entire total return of the S&P 500 during the complete market cycle from 2007-2020 occurred during periods when our measures of market internals were uniformly favorable, with T-bills outpacing the S&P 500 with lower risk otherwise. As I’ve detailed extensively, the one thing that made the recent bull market “different” from prior market cycles was that historically-reliable “overvalued, overbought, overbullish” extremes did nothing to contain speculation amid the novelty of zero interest rate policy. In 2017, we abandoned our willingness to pre-emptively adopt a bearish outlook in response to these syndromes if our measures of internals are still favorable.

That’s not to say that the market always declines when internals are unfavorable. Rather, whatever gains the S&P 500 enjoys in excess of T-bills when internals are unfavorable, even during the late stages of a bubble, typically prove to be impermanent.

One of the things to remember about investing is that the higher the price you pay today, for a given stream of future cash flows, the lower the long-term returns you can expect. It’s exactly when past returns are most glorious that future prospects are most dismal.

There’s enormous value in understanding that market valuations are the main drivers of long-term investment returns and the extent of potential market losses over the complete market cycle, while investor psychology typically matters more over shorter segments of the market cycle. Sufficiently extreme conditions can still warrant a neutral outlook even in periods when internals are favorable, but in general, it’s best to avoid a hard-negative outlook when internals are favorable, and to avoid leveraged or fully-unhedged investment stances when they are unfavorable.

So we’re clear – psychology and internals matter, and we’ll discuss those more shortly.

But from a valuation standpoint…

Yikes

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. The same outcome accompanied the decade following the 2000 market peak.

The chart below shows our estimate of average annual nominal total returns for a conventional passive portfolio mix invested 60% in the S&P 500, 30% in Treasury bonds, and 10% in Treasury bills. As of August 28, that estimated 12-year total return has declined to -0.95%, easily the lowest level in history, including the extreme low associated with the 1929 market peak. The red line shows actual realized total returns on this portfolio mix over the same 12-year periods.

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. Examine market history, and you’ll notice that the profile of expected returns is constantly changing, and occasionally spikes higher. Those upward spikes in projected returns are driven by downward spikes in valuations.

The best opportunity to embrace market risk, in my view, is when a material retreat in valuations is joined by an early improvement in the uniformity of market internals.

Below the surface

One of the features of our measures of market internals is that they can be unfavorable even when the S&P 500 is hitting new highs, and can become positive even when the market seems quite weak. The critical thing to remember is that we need to look below the surface.

That’s why they’re called internals.

Presently, one of the striking aspects of market behavior is the lack of confirmation that has accompanied recent market highs. While the S&P 500 and the Nasdaq Composite have pushed to record highs, neither the broad NYSE Composite, small-cap Russell 2000, Dow Industrials, Dow Utilities, or Value Line indices have breached their February peaks. Likewise, daily market action has increasingly featured divergences, with more declining stocks than advancing stocks even on days when the S&P 500 moves higher, with increasing implied volatility in stock index options even on market advances. Likewise, nearly half of all U.S. stocks remain below their respective 200-day moving averages.

There’s enormous value in understanding that market valuations are the main drivers of long-term investment returns and the extent of potential market losses over the complete market cycle, while investor psychology typically matters more over shorter segments of the market cycle. Sufficiently extreme conditions can still warrant a neutral outlook even in periods when internals are favorable. Still, in general, it’s best to avoid a hard-negative outlook when internals are favorable, and to avoid leveraged or fully-unhedged investment stances when they are unfavorable.

Meanwhile, we’re observing extremely lopsided bullishness, with Investors Intelligence reporting 60% bulls and just 16.2% bears among investment advisors – the widest spread since the January 2018 pre-correction peak. The National Association of Investment Managers reports that the average exposure of its members is presently 106.6%. While the most bearish exposure reported by NAAIM members is typically a short position with an average value of about -80%, the most bearish position currently reported among NAIAIM members is a 50% long position. Again, the only time we’ve observed similar bullishness was at the January 2018 pre-market peak.

In this context, it’s worth observing that the trajectory of the S&P 500 since January 2018 has taken the form of a huge “megaphone,” punctuated by multiple corrections that have regularly wiped out the market’s interim progress, as we saw in late-2018, May 2019, August 2019, and again early this year. Between January 26, 2018 and April 21, 2020, the total return of the S&P 500 index was negative. In my view, it’s primarily the blind faith of investors in a “Fed backstop” in recent months that has enabled an extension of market valuations to the most extreme levels ever observed in history.

In the options market, the 5-day equity put/call ratio on the Chicago Board Options Exchange has dropped to just 0.406, the lowest level in nearly 20 years, last seen briefly in January 2001, during the first bear market rally of the 2000-2002 market collapse. The lack of investor interest in put options reflects extreme confidence that the Fed has already given them a “put” in the form of a monetary “backstop.” The closest the put/call has come to this level in recent years was on April 15, 2010, immediately before a 16% correction. Extreme bullishness can and often does coincide with ragged internals, and the combination is often quite unfavorable, because it’s a sign that “surface” speculation rests on a weak foundation.

In recent weeks, we’ve also begun to observe various syndromes of conditions that we monitor in daily data, which have historically been vulnerable to abrupt “air pockets” or sustained declines. The chart below, for example, shows periods that join overbullish sentiment with even mildly divergent behavior in implied volatility and market participation. Specifically, the red bars identify instances when advisory bears were below 27%, the CBOE put/call ratio was below 0.58, at least 3 days in the past 10 combined an advance in the S&P 500 with an increase in the VIX, and fewer than 68% of individual stocks were above their own respective 200-day averages. Notably, every steep correction since January 2018 has been preceded by these conditions, not to mention the precise market top in March 2000.

Another interesting combination features the S&P 500 within 0.5% of a 5-year high, a 14-day change in excess of 1%, with fewer than 3% of NYSE issues at new 52-week highs and fewer than 60% of individual stocks above their own 200-day averages. Again, while these conditions are quite simple, the combination of market highs and tepid internals is often a warning sign.

An even less frequent variant that we presently observe in daily data is the combination of S&P 500 highs and narrow participation, adding extremely lopsided sentiment. The chart below shows points when the S&P 500 was within 0.5% of a 5-year high, advisory bears were below 27%, the CBOE put/call ratio was below 0.58, fewer than 3% of NYSE stocks were at 52-week highs, and fewer than 60% of individual stocks were above their own 200-day averages. The instances here are quite limited and rather precise, occurring within days of the March 2000 peak, the October 2007 peak, the September 2018 pre-correction peak, and today.

None of these are forecasts, but they illustrate the confluence of negative factors and syndromes that we are presently observing. It should also be clear that none of this is new. They are just variants of risk factors that I’ve noted in real-time across decades of market cycles.

The Fed is like a guy who imagines that repeatedly pushing a button will control the economy, when the button is actually wired to the pleasure center in Davey Day Trader’s brain, along with millions of other speculators whose bubble-chasing behavior creates the setup for yet another financial collapse.

Nobody needs your promise to lay on that button, Jay. The only activities enabled by zero yields are those that can’t survive even a tiny hurdle rate. They’re activities where leveraged finance is the primary cost of doing business. That’s how an activist Fed has created a yield-seeking bubble and the issuance of a mountain of low-grade debt that puts 1929 to shame.

"Capital needs to cost something for a dynamic economy to work."

– Sheila Bair, former FDIC Chair

Read more here…


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