“Historically, when trend uniformity has been positive, stocks have generally ignored overvaluation, no matter how extreme. When the market loses that uniformity, valuations often matter suddenly and with a vengeance. This is a lesson best learned before a crash rather than after one.”
– John P. Hussman, Ph.D., October 3, 2000
“One of the best indications of the speculative willingness of investors is the ‘uniformity’ of positive market action across a broad range of internals. Probably the most important aspect of last week’s decline was the decisive negative shift in these measures. Since early October of last year, I have at least generally been able to say in these weekly comments that “market action is favorable on the basis of price trends and other market internals.” Now, it also happens that once the market reaches overvalued, overbought and overbullish conditions, stocks have historically lagged Treasury bills, on average, even when those internals have been positive (a fact which kept us hedged). Still, the favorable market internals did tell us that investors were still willing to speculate, however abruptly that willingness might end. Evidently, it just ended, and the reversal is broad-based.”
– John P. Hussman, Ph.D., July 30, 2007
When one examines market cycles across history, including the most extreme speculative bubbles, one typically finds segments where valuations were clearly elevated relative to historical norms, and yet the stock market continued to advance. Still, one also finds that the market dropped like a rock over the completion of the market cycle. Likewise, one finds that virtually every point of significant overvaluation was systematically followed by below-average total market returns over a 10-12 year horizon.
It’s precisely the failure of valuations to matter over shorter segments of the market cycle that regularly convinces investors that valuations don’t matter at all. This delusion is strikingly ingrained into investor behavior, and is almost inescapably revived during every speculative episode. As Graham and Dodd wrote in Security Analysis (1934), referring to the final advance that led to the 1929 market peak, the reason investors shifted their attention away from historically-reliable measures of valuation was “first, that the records of the past were proving an undependable guide to investment; and, second, that the rewards offered by the future had become irresistibly alluring.” The consequence of the delusion that “old valuation measures no longer apply” was predictably wicked, as it was after the 1969, 1972, 2000 and 2007 extremes. What’s distressing is that this delusion is actively encouraged by investment professionals who ought to know better.
Valuations seem unreliable during speculative episodes because investors neglect a critical distinction. While long-term and full-cycle market outcomes are tightly determined by market valuations, the effect of valuations on outcomes over shorter segments of the market cycle depends on the psychological preference of investors toward speculation or risk aversion. When investors are inclined to speculate, they tend to be indiscriminate about it, and for that reason, we’ve found that the most reliable measure of investor psychology is the uniformity or divergence of market action across a wide range of individual stocks, industries, sectors, and security types, including debt securities of varying creditworthiness.
Our own measures of market action extract a signal from the behavior of thousands of securities, and are not captured by simple indicators like 200-day moving averages or advance-decline lines. Still, as a rule-of-thumb, divergence in the behavior of a broad range of individual stocks from the behavior of the major indices tends to be a warning sign, as do widening credit spreads, or lack of uniformity in the behavior of various market sectors.
Put simply, when valuation measures are steeply elevated but investors remain inclined to speculate, as evidenced by very broad uniformity of market action and the absence of internal divergences, rich valuations often have little effect on market outcomes. However, in an environment of extreme valuations, even fairly subtle deterioration in the uniformity of market internals should be taken as a signal of increasing risk-aversion among investors, and the market becomes vulnerable to steep and abrupt losses.
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