Last week, the U.S. equity market climbed to the steepest valuation level in history, based on the valuation measures most highly correlated with actual subsequent S&P 500 10-12 year total returns, across a century of market cycles.
As Didier Sornette correctly observed in Why Markets Crash,
“The collapse is fundamentally due to the unstable position; the instantaneous cause of the crash is secondary.”
My sense is that investors are going to learn this again the hard way.
On the accelerating slope of the current advance
Speaking of Didier Sornette, I’ve periodically discussed his concept of “log periodic power-law” price behavior, which has accompanied speculative episodes in numerous markets and often precedes inflection points or collapses. This structure is based on a purely mathematical fit to price behavior, and does not reflect any valuation considerations. It’s not part of our own investment discipline, but we occasionally fit the log-periodic structure to price behavior when market movements are particularly extreme.
In recent years, those structures have generally identified inflection points of flat or correcting prices, but certainly not crashes in the S&P 500. Given the increasingly steep slope of the current market advance, along with the most extreme valuations in history and the most lopsided bullish sentiment in more than three decades, it’s quite possible that this instance will be different. In any event, the underlying “arbitrage” considerations described by Sornette are worth reviewing here.
In 2000, as the tech bubble was peaking, Nobel laureate Franco Modigliani observed that the late stages of a bubble can be “rational” in a certain sense, provided that investors are inclined to self-reinforcing behavior.
Imagine a market that you fully believe to be overvalued and at risk of a market crash. Indeed, let’s say that there is a defined probability of a crash, which increases rapidly as the pitch of the market advance becomes more extreme. Should you sell? Well, it depends. Given that an immediate crash is not certain, a speculator must, in each period, weigh the potential gain from holding a bit longer against the potential loss from overstaying. Sornette uses a similar argument to describe a speculative bubble advancing toward its peak (italics mine):
“Since the crash is not a certain deterministic outcome of the bubble, it remains rational for investors to remain in the market provided they are compensated by a higher rate of growth of the bubble for taking the risk of a crash, because there is a finite probability of ‘landing smoothly,’ that is, of attaining the end of the bubble without crash.”
“This line of reasoning provides us with the following important result: the market return from today to tomorrow is proportional to the crash hazard rate. In essence, investors must be compensated by a higher return in order to be induced to hold an asset that might crash. As the price variation speeds up, the no-arbitrage conditions, together with rational expectations, then imply that there must be an underlying risk, not yet revealed in the price dynamics, which justifies this apparent free ride and free lunch. The fundamental logic here is that the no-arbitrage condition, together with rational expectations, automatically implies a dramatic increase of a risk looming ahead each time the price appreciates significantly, such as in a speculative frenzy or in a bubble. This is the conclusion that rational traders will reach.”
The chart below shows our current best-fit parameterization of Sornette’s log-periodic structure, applied to the S&P 500 Index. Notably, unless we allow for the slope of the current market advance to become quite literally infinite, it’s impossible to closely fit the current price advance without setting the “finite-time singularity” – the point at which instability typically emerges – within a few days of the present date. Notably, the singularity is not the date of a crash. Rather, it’s the point where the pitch of the advance reaches an extreme, which may simply be an inflection point (as has been the case for other structures in recent years) or a pre-crash peak.
The collapse is fundamentally due to the unstable position; the instantaneous cause of the crash is secondary.
– Didier Sornette
If you want my opinion (which we don’t trade on and neither should you), my opinion is that this singularity will prove to be more than an inflection point.
Though nearly every morning prompts the phrase “Yup, they’re actually going to do this again,” the steepening pitch of this ascent – coupled with record valuation extremes, record overbought extremes, and the most lopsided bullish sentiment in over three decades – now produces the most extreme “overvalued, overbought, overbullish” moment in history. In prior cycles across history, similar syndromes were either joined or quickly followed by deterioration in market internals. In this cycle, it has been essential to wait for explicit deterioration in market internals before establishing a negative outlook. Notably, the market has lost value, even since 2009, when overvalued, overbought, overbullish conditions were joined by divergent internals.
I expect the S&P 500 to lose approximately two-thirds of its value over the completion of this cycle.
My impression is that future generations will look back on this moment and say “… and this is where they completely lost their minds.”
As I’ve regularly noted in recent months, our immediate outlook is essentially flat neutral for practical purposes, though we’re partial to a layer of tail-risk hedges, such as out-of-the-money index put options, given that a market decline on the order of even 5% would almost certainly be sufficient to send our measures of market internals into a negative condition. It’s best not to rely on the ability to execute sales into a falling market, because the range-expansion we’ve recently seen on the upside may very well have a mirror-image on the downside. As usual, we’ll respond to new evidence as it emerges.