We continue to classify market conditions among the most hostile expected return/risk profiles we identify. The current profile joins rich valuations with continued evidence of a subtle shift toward risk aversion among investors, which we infer from market internals (a variant of what we used to call “trend uniformity”), credit spreads, and other risk-sensitive measures.
Liquidity in both the stock and bond markets is thinning considerably. In bonds, quantitative easing by global central banks has resulted in a scarcity of available collateral, a collapse inrepo liquidity, and increasing frequency of delivery failures, all of which is shorthand for a bond market that is becoming less liquid and more fragile to any credit event. Meanwhile, risk premiums are minuscule. Avoiding a negative total return on 10-year bonds now requiresthat interest rates must not rise by even one percentage point over the next three years. Bond yields have historically covered investors against a meaningful change in yields before resulting in negative total returns. On a one-year return horizon, bond yields presently cover investors for a yield change amounting to only about 0.25 standard deviations – matching mid-2012 as the lowest level of yield coverage in history.
In equities, price-volume action continues to show characteristics of distribution and growing illiquidity. The distribution shows up as periodic bursts of high-volume selling, followed by low volume advances as those modest pools of sellers back off and short-covering squeezes prices higher.
Baupost's investment process involves "never-ending" gleaning of facts to help support investment ideas Seth Klarman writes in his end-of-year letter to investors. In the letter, a copy of which ValueWalk has been able to review, the value investor describes the Baupost Group's process to identify ideas and answer the most critical questions about its potential Read More
As we’ve seen across history, the problem with overvalued, overbought, overbullish markets with thinning liquidity and increasing risk aversion is that once a meaningful segment of speculators tries to sell, they find that there’s no natural demand at nearby prices, since value-conscious investors have no inclination to accumulate overvalued equities except at far lower prices that remove that overvaluation. Market crashes always reflect two features: extremely thin risk premiums in an environment where investors have shifted toward greater risk-aversion, and lopsided selling into an illiquid market. Under present conditions, we observe the precursors for both. That doesn’t force or ensure a crash, but it creates the underlying fragility that allows one.
Even at presently wicked overvaluation, a favorable shift in market internals and credit spreads could move us to a fairly neutral or marginally constructive market outlook, and at least defer the immediacy of our concerns about vertical market losses. More flexibility for a constructive outlook would result from even a modest clearing of overvalued, overbought, overbullish conditions, coupled with improved market internals. A material retreat in valuations, followed by a favorable shift in market internals, would provide scope for a clearly constructive or even aggressive market outlook, as we adopted after the 1990 bear market, the 2000-2002 bear market, and even after the late-2008 market plunge (though that shift was truncated by my 2009 insistence on stress-testing our methods against Depression era data). Those improved conditions are worth waiting for, just as extreme risks presently warrant heightened defenses.
The Nasdaq breaks even
Last week, the Nasdaq Composite finally clawed its way to breakeven, 15 years after its spectacular bubble peak in 2000. It’s a testament to the overvaluation of technology stocks in 2000 that it has required the third equity bubble in 15 years to reclaim that 2000 high, at least briefly. As you may remember, the Nasdaq Composite reached its intra-day high of 5132.52 in March 2000, plunging to 795.25 (down -78%) by October 2002. The Nasdaq 100, representing the most glamourous of the group, peaked at 4816.25 in March 2000, plunging to 795.25 (down 83%) by October 2002. Even a decade later, in 2010, both indices were still 60-65% below their 2000 highs. The 2000-2002 decline also took the S&P 500 down by half, wiping out the entire total return of the S&P 500 – in excess of Treasury bill returns – all the way back to May 1996.
It’s instructive to look back on the comments that we published in 2000 as the bubble, in hindsight, was about to burst:
“The issue is no longer whether the current market resembles those preceding the 1929, 1969-70, 1973-74, and 1987 crashes. The issue is only – are conditions more like October of 1929, or more like April? Like October of 1987, or more like July? If the latter, then over the short term, arrogant imprudence will continue to be mistaken for enlightened genius, while studied restraint will be mistaken for stubborn foolishness. We can’t rule out further gains, but those gains will turn bitter… Let’s not be shy: regardless of short-term action, we ultimately expect the S&P 500 to fall by more than half, and the Nasdaq by two-thirds. Don’t scoff without reviewing history first.”
– Hussman Econometrics, February 9, 2000
“Investors have turned the market into a carnival, where everybody ‘knows’ that the new rides are the good rides, and the old rides just don’t work. Where the carnival barkers seem to hand out free money for just showing up. Unfortunately, this business is not that kind – it has always been true that in every pyramid, in every easy-money sure-thing, the first ones to get out are the only ones to get out… One of the things that you may have noticed is that our downside targets for the market don’t simply slide up in parallel with the market. Most analysts have an ingrained ‘15% correction’ mentality, such that no matter how high prices advance, the probable maximum downside risk is just 15% or so (and that would be considered bad). Factually speaking, however, that’s not the way it works… The inconvenient fact is that valuation ultimately matters. That has led to the rather peculiar risk projections that have appeared in this letter in recent months. Trend uniformity helps to postpone that reality, but in the end, there it is… Over time, price/revenue ratios come back into line. Currently, that would require an 83% plunge in tech stocks (recall the 1969-70 tech massacre). The plunge may be muted to about 65% given several years of revenue growth. If you understand values and market history, you know we’re not joking.”
– Hussman Econometrics, March 7, 2000
As it happened, the SPX dropped by half, and the tech-heavy NDX dropped by 83%. If one was attentive to valuations, the spectacular losses from the 2000 peak were actually right on target. And though the reasons to believe that “this time is different” are not the same as in 2000, the same lessons – and similar risks – are relevant to investors today.
Where is “fair value” today? We have to be careful here because the concept of “fair” depends on your assumptions about what a reasonable investment return should be. If I show you a security that’s expected to pay out $100 ten years from today, and I tell you that the current price is $82, you can quickly calculate that the expected return on that security is 2% annually – and you don’t need to know anything about interest rates to do that arithmetic. Interest rates come in after you do that arithmetic. Interest rates then matter only because they give you something to compare with that 2%. Now, if you decide that a 2% annual return over the coming decade is just fine with you, in view of competing alternatives, then it’s fine to call that security “fairly valued.” But even if you decide that the security is fairly valued, you should still expect a 2% annual return over the coming decade. If you viewed a 10-year return of 8% as reasonable, you’d peg “fair value” at $46.32.
On the basis of valuation measures best correlated with actual subsequentmarket returns, we can say with a strong degree of confidence that the S&P 500 would presently have to drop to the 940 level in order for investors to expect a historically normal 10-year total return of 10% annually. That 940 figure for the S&P 500 would not represent some extreme, catastrophic outcome. It’s not a level that would even represent undervaluation from a historical perspective. It’s the level that we would associate with average, historically run-of-the-mill long-term equity returns. As we observed at the 2000 peak, “if you understand values and market history, you know we’re not joking.”
That said, if one believes that depressed interest rates warrant not only a low prospective return on stocks, but also virtually no risk premium whatsoeverdespite their significant full-cycle volatility, then you might be quite happy with the prospect of a 1.4% annual nominal total return on the S&P 500 over the coming decade, which is what we presently estimate from current levels, based on a variety of historically reliable methods (see Ockham’s Razor and the Market Cycle for the arithmetic behind these estimates). In that case, you might consider stocks to be “fairly valued” here. But you should still allow for a 940 level or below on the S&P 500 over the completion of this market cycle.
One might think that low interest rates would preclude the possibility of the market losing more than half of its value, but historically, one would be wrong. Outside of the inflation-disinflation cycle from the mid-1960’s to the mid-1990’s, the historical correlation between 10-year Treasury yields and 10-year prospective stock returns has been far weaker than investors seem to believe. Indeed, except for the 2000-2002 cycle, the final low that completes a market cycle has historically taken the market well below run-of-the-mill valuation norms, even in periods prior to the mid-1960’s when interest rates were similarly low and much more stable. One might think that Fed easing would preclude that possibility, until you realize that the Fed was easing aggressively and continuously throughout the 2000-2002 and 2007-2009 collapses.
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