by Erik McCurdy, Prometheus Market Insight
Last year, the risk/reward profile of the stock market increased to the worst 1 percentile of all historical observations during the last 100 years. The brief correction during the fourth quarter relieved that condition temporarily, but the speculative surge during the last two months has once again increased stock market risk to the highest level on record. In his latest weekly commentary, fund manager John Hussman reviews the high-risk syndrome that has been followed by severe declines in almost every instance during the last 50 years.
Last week, the S&P 500 advanced the extra 1% required to re-establish virtually every “overvalued, overbought, overbullish, rising-yields” syndrome that we define – syndromes that have appeared at or close to the beginning of what investors can easily recall as the singularly worst set of market instances in history, including the 1973-74, 1987, 2000-2002, and 2007-2009 plunges. With some minor imputation (estimating bullish and bearish sentiment as a function of the extent and volatility of prior market movement), we can verify that these syndromes also emerged just prior to the 1929-1932 collapse.
The S&P 500 is presently near or through its Bollinger band (2 standard deviations above its 20-period moving average) at daily, weekly and monthly resolutions, the Shiller P/E (S&P 500 divided by the 10-year average of inflation-adjusted earnings) is above 22, Investors Intelligence reports lopsided sentiment at 53.2% bulls versus 22.3% bears, the S&P 500 is well into a mature bull market and Treasury bond yields have advanced measurably.
The blue lines over the chart of the S&P 500 below are even sparser than our typical charts of “overvalued, overbought, overbullish, rising-yield” events, and identify the points where the S&P 500 was within 3% of its upper Bollinger bands, at least 7% above its 52-week smoothing, and over 50% above its 4-year low, with bulls above 52% and bears below 27%, a Shiller P/E above 18, and 10-year Treasury yields above their level of 6-months earlier. As I often note, there are numerous ways of defining syndromes like this. The conditions here are essentially a way of identifying what have normally been the most strenuously overvalued, overbought, overbullish, rising-yield points within already mature market advances. Investors who are willing to accept present, record profit margins (about 70% above historical norms) as permanent will reject the notion that stocks are overvalued, but I trust that the evidence we’ve presented over time underscores the deeper basis for that conclusion. See last week’s comment Declaring Victory at Halftime for the relationship between profits as a share of GDP and subsequent earnings growth, Too Little to Lock In for the link between deficit spending and corporate profits, and Overlooking Overvaluation for the relationship between various valuation metrics and subsequent market returns.
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For optimists, there is a false one-week signal in 1997 – during the internet bubble – that was not associated with a negative follow-through. That is, as long as one ignores that the S&P 500 was essentially unchanged 5-years later, underperformed Treasury bills for the next 12 years, and even through last week’s advance, has outperformed Treasury bills by less than 2% annually in the nearly 16 years since then (all of which would be surrendered by even a run-of-the-mill bear market decline – and then some). There is also a fairly uneventful signal in mid-1964 that was not followed by near-term losses, though the market was still lower two years later and would underperform Treasury bills for the next 20 years.
Notably, during the recent bull market advance, we’ve seen conditions as extreme as at present only once – in early 2011, just prior to a nearly 20% market loss, though not rivaling the 30-50% plunges that this syndrome has also captured.
My concerns here are understandably easy to dismiss given that the S&P 500 is now more than 5% higher than it was in March of last year, when our estimates of prospective return/risk (on a smoothed horizon from 2-weeks to 18 months) first plunged into most negative 1% of market history. Yet despite the intervening monetary heroics, history suggests not that these conditions will persist without resolution, but instead that their resolution is likely to be that much worse. Anyone who followed me in 2000 or 2007 will easily recall a similar frustration before the bottom fell out of the market on each occasion. I can’t assure that the same will occur in the present case, but I believe it would be reckless to assume that the Fed has these risks covered. With margin debt over 2% of GDP as it was on three prior occasions – 2000, 2007 and early 2011 – it’s clear that investors are all-in when it comes to faith in the Fed. Still, when an investment thesis becomes so universally embraced and so apparently easy to follow that anyone who resists is considered foolish (as was the case with tech stocks in 2000), my risk aversion needle hits the red zone.
If the defensiveness of a supposed permabear seems hard to swallow even with the S&P 500 pushing its upper bands in a mature bull market, here’s what I would suggest. Carefully identify what has ultimately (not temporarily) been unlikeable or incorrect about my investment views over the years. For most people who follow my work, the main answer will be my insistence on remaining defensive in 2009 (despite the success of our approach to that point) until I was certain that our methods were robust to “out of sample” Depression-era data. There are also several points in recent years when trend-following measures were favorable – but without the presence of hostile “overvalued, overbought, overbullish” syndromes – where some added emphasis on trend-following measures would have helped in the face of unprecedented monetary intervention (unfortunately, constructive trend-following measures have historically been of little help to prospective returns once overvalued, overbought, overbullish syndromes have kicked in).
The ensemble methods that resulted from that 2009-early 2010 “two data sets” challenge, and criteria to increase the frequency of constructive positions when our trend-following measures are favorable (absent hostile syndromes, but even when our return/risk estimates are negative), represent the two material changes we’ve made to our approach since 2000 (see Notes on an extraordinary market cycle). This past cycle was extraordinary because it featured not just risk (the negative portion of a reasonably known range of outcomes), but also extreme uncertainty (the lack of knowledge about the range of outcomes that are even possible). The 2009 “miss” did not result from applying our present methods, but as I noted at the time, resulted from the need to address a “two data sets” problem in a world where Depression-era outcomes had become possible. It’s not entirely clear whether future cycles could invite Depression-like outcomes, rapid inflation, or unforeseen fiscal strains. What I do believe is that our approach to estimating prospective market return/risk (incorporating ensemble methods) is robust to “out of sample” data, and can engage those uncertainties – if they emerge – without further changes. It’s clear that what I saw as a necessary stress-testing response in 2009 ended up injuring not only my record, but my reputation, and the trust of those who rely on my work. I do believe it made us far stronger, but time will tell, and I don’t expect that we will require a great deal of it.
In any event, one can hardly embrace our 2000-2002 and 2007-2009 defensiveness (not to mention our intervening bullish shift in early 2003), and at the same time reject our present defensiveness, because what our approach indicates today is what it would have correctly indicated in similar conditions in numerous other cycles. None of this ensures that stocks will not advance to further extremes in the near-term. Regardless, I have very little doubt that investors will observe better – or spectacularly better – points at which to accept market risk, when the evidence does not ask them to rely on the hope that a strenuously overvalued, overbought, overbullish market will become more so.
As always, it is important to remember that there are no certainties when it comes to financial market forecasting, only possibilities and their associated probabilities. A speculative market of this nature can always become even more so over short-term time frames. However, from a long-term investment perspective, stock market risk is now at the highest level on record. At a current duration of 46 months, the cyclical bull market from 2009 is overdue for termination and the next cyclical top could form at any time.
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It is easy to become caught up in the euphoria and despair that accompany violent, short-term price swings. However, the primary key to achieving long-term success as both an investor and a trader is to remain focused on the big picture. The historically poor risk/reward profile of the stock market urges caution at the moment, so we remain fully defensive from an investment perspective.
Note: This article appeared in the Prometheus Investing Thought box halfway down the right hand column on our front page, just above the Video of the Day, on Tuesday 22 January 2013. Several thoughts are published each week. The two latest thoughts from Prometheus are always available here.
