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Brief notes
There are certain features of valuation, investor psychology, and price behavior that emerge, to one degree or another, when the fear of missing out becomes particularly extreme and the speculative focus becomes particularly narrow. It suddenly hit us Mother from those circumstances. Of course, these are not expectations. It is a statement about current observable conditions.
“Noise reduction is always the process of drawing a combined signal from multiple, partially interconnected sensors, even if each individual sensor is imperfect. The reason we track boatloads of these syndromes is the same reason we base our internal measure of the market on thousands for papers.” Financial – standardization conveys information.”
-John P. Housman, Ph.D., MotherlodeNovember 20, 2021
Our investment discipline is to align our expectations with current, measurable and observable market conditions – especially valuations and internal market conditions – and To change that outlook as circumstances change. In previous market cycles throughout history, it was also possible to respond immediately to “overvalued, overbought, overbullish” market fluctuations, which provided a kind of “limit” to speculation even before market internal factors clearly deteriorated. Amid speculation driven by zero interest rate policies, speculation has lost its “limits,” and we have abandoned our bearish response to overexpansion syndromes. Excludes In periods when there are internal factors in the market also Not suitable. It is the striking uniformity of hostile conditions – extreme valuations, unfavorable market internals, and the preponderance of overextended syndromes – that prompts a temporary suspension.
Measured against the market’s peak in January 2022, the S&P 500’s total return was lagging the return of Treasuries through April of this year. Meanwhile, our valuations and internal market metrics remained unfavorable. With the market seeming to be skating around the door of extreme valuations and unfavorable internal factors without consequence, the rush to new highs in the past few weeks has created the impression of runaway progress.
As I noted in late 2021, there are certain features of valuation, investor psychology, and price behavior that tend to emerge when the fear of missing out becomes particularly extreme and the speculative focus becomes particularly narrow. Last Friday, we arrived at a new “home” for these conditions. Since the mid-1980s, I have developed and collected dozens of interesting syndromes and relationships that help measure overextended states, in both directions. Sometimes I add, ignore, or tweak one or two, but for the most part, I’ve been using the same set for years. The most significant change in 2021 has been the demand that our measure of market internals deteriorate, no matter how stretched the conditions may otherwise be.
We retain ownership of internal market details and many technical measures, but are very open about general features. A red flag is usually a combination of: excessive valuations and price/volume behavior; Unbalanced emotions or speculative attitudes; The difference between individual stocks, industries, sectors, or types of securities such as bonds or low-grade credit. The chart below shows the current number of hyperextension syndromes, in weekly data. The blue line is the S&P 500 (right scale). Thin blue lines indicate periods when at least 30% of these syndromes were active.
In recent months, I have expanded the set of similar syndromes that we monitor in daily data, including downside stress syndromes, which I have discussed periodically in special updates over the years. The red bars show a number of technical factors – mainly characterized by extended market action coupled with divergent internal factors – which are often present at intermediate market tops. The green bars show technical factors, mainly stress syndromes, which are often present at intermediate lows. The blue line is the S&P 500 (left scale).
At present, the “last straw” in market movements that is worth monitoring in daily data is related to “leadership”. An expansion in the number of stocks hitting 52-week lows (up to 2.5-3% of issues traded) amid new highs in major indices tends to be a feature of market fatigue. The reason is the same as I pointed out near the market peak in 2007:
One of the best indicators of investors’ willingness to speculate is the “consistency” of positive market actions across a wide range of internal factors… I have observed over the years that large market declines are often preceded by a combination of internal dispersion, with the market simultaneously recording a large A relatively small number of new highs and new lows among individual stocks, and a leadership reversal, where statistics shift from a majority of new highs to a majority of new lows within a small number of trading sessions.
“This is very similar to what happens when a substance undergoes a ‘phase transition’, for example, from a gas to a liquid or vice versa. Parts of the substance begin to behave distinctly, as if the molecules are choosing between the two phases. As the transition approaches,’ Critical Point”, you begin to observe larger clusters where one phase takes precedence and the particles that have “made a choice” influence their neighbours. You also observe rapid oscillations between order and chaos in the remaining particles so the transition phase is characterized by internal dispersion followed by a reversal of leadership. My impression is that this The measurement also extends to the market’s tendency to experience increased volatility at 5-10 minute intervals before significant declines.
-John P. Housman, Ph.D., Market Internals Go Negative, July 30, 2007
I still view the market’s advance in recent months as an attempt to “catch the foam of yesterday’s bubble” rather than a new and lasting bull market advance. I also believe the S&P 500 could lose something in the range of 50% to 70% as this cycle completes, simply in order to bring long-term expected returns to the usual benchmarks that investors associate with stocks. However, as you also note in almost every market commentary, usually with the word “definitely,” nothing in our investment system is based on any forecast of near-term market movement, nor on valuations returning to their long-term historical norms.
The chart below shows our most reliable valuation measure: the ratio of non-financial market capitalization to gross corporate value added, including estimated foreign revenues. The current level exceeds the maximums reached in 1929 and 2000, and exceeds every point in US history except those closely surrounding the early 2022 peak. And even the more traditional (but less reliable) S&P 500 forward price/operating earnings multiple It is at levels that have no rivals, except around the peaks reached in 2000 and 2022. Simply put, my impression is that the period since early 2022 includes the extended peak of one of the three great speculative bubbles in US history.
The S&P 500 has averaged annual nominal total returns of approximately 7.3% since 2000. This result represents 4.3% of nominal revenue growth, plus an average dividend yield of 1.9%, plus an additional 1.1% per year, which It was achieved by pushing the S&P 500 price/revenue multiple from the 2000 maximum of 2.2 to the more extreme level of 2.8.
This is how mathematics works. Price = Price / Revenue x Revenue. Shake these two ingredients. Add profits. Chill and serve. Since 2000, investors have received more returns from 4.3% revenue growth as well as 1.9% dividends. Just By pushing the price/revenue multiple to record levels. Now move valuations in the other direction, and the decline in valuations is a subtraction of long-term returns. The math is the same for any other valuation multiples you prefer. It is noisier for fundamentals such as profits, where much of this noise is driven by variation in profit margins – reflecting impermanent changes in interest costs and cyclical fluctuations in real unit labor costs.
Clearly, nothing requires investors to demand normal long-term returns. Assuming continued nominal revenue growth of 4.3% per year and adding the current S&P 500 dividend yield of 1.4%, the “perpetually high stickiness” in valuations implies total expected nominal returns on the S&P 500 over the long term of about 5.7% per year. . Perhaps needless to say, I consider this estimate to be quite optimistic, especially based on how history has liberalized the idea of the “permanently high plateau.”
With our most reliable valuation metrics at between 2.8 and 3.2 times their historical benchmarks, briefly touching those benchmarks a decade from today would subtract 9.8 to 11.0% per annum from a baseline of 5.7%, implying total returns In the range of -4.1% to -5.3% annually. Again, this is just a calculation. Even a slight pullback from the “permanently high plateau” would be enough to pull estimated 10-year total returns into the low single digits. With current extreme valuations, it is almost incomprehensible how popular passive investing and expecting satisfactory long-term returns are in the stock market. He depends Assuming permanently high and rising valuations.
At the same time, if one expects higher returns as a result of nominal growth due to unchecked inflation, it is useful to examine the behavior of valuations during inflationary periods, both in the United States and elsewhere. In general, stock prices invariably only benefit from higher inflation after Ratings have been pushed to low levels. For now, the CPI will have to do that Triple In order for the positive impact of inflation on nominal fundamentals to outweigh the potential negative impact of rapid and sustained inflation on valuations.
To learn more about the calculation linking valuations, cash flows, and long-term investment returns, see Structural drivers of investment returns. For a deeper dive into the profit margins and dynamics of mega-cap stocks, see Global Capitulation and No Margin of Safety.
Finally, a note on the “innovation” story that encourages investors to believe that “this time is different,” as has happened in every speculative episode in history. As Business Week wrote in 1929: “This delusion is summed up in the phrase ‘New Age.’ The phrase itself is not new, and every period of speculation rediscovers it.” Amid the wild extrapolations from every angle, a few observations may provide a useful reality check:
- The biggest driver of margin expansion in recent decades has not been technological innovation, but rather lower interest rate costs, which were temporarily capped by massive refinancing in 2020 and 2021;
- Growth rates and operating margins for major stocks are not fixed numbers but trajectories.
- Long-term growth across the economy has already occurred always This was driven by innovation and productivity, with leading companies initially enjoying high profits and growth rates experiencing recurring cycles of creative destruction as new industries expanded.
- If the total revenues of the S&P 500 and US GDP had averaged real annual growth of less than 2.5% per year over the past 30 years, Even taking advantage of all this innovation (they did), and one can make a case that the increase in corporate profit margins over that period is largely related to lower interest costs (one can). It is a mistake to value the entire market at standard multiples simply because some companies enjoy network effects that give them the ability to hoard… Market share. Cash flows are concentrated in fewer hands.
- Network effects and near-monopoly can slow and postpone the erosion of profit margins, but they do not eliminate longer-term competition (as every major corporation that has fallen in history has learned from us).
Our investment system is responsive to market conditions that change over time. Our adjustments in 2021 encourage an aggressive outlook (leveraged frequently, for example, in the early 1990s) or a constructive outlook (perhaps with position limits or safety nets) in about two-thirds of historical periods, and more than half of them. Of the periods since the market decline in 2009. Constructive market conditions will emerge soon enough, albeit locally and intermittently at first. We do not consider these conditions here at all.
Original post
Editor’s note: The summary points for this article were selected by Seeking Alpha editors.
