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Departures from long-term growth trends again extreme

by xyonent
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Bull Market Stock Chart.jpg

In 2022, we discussed deviations from the market’s long-term growth trends, and the discussion centered around Jeremy Grantham’s commentary on market bubbles. In other words:

All of the 2-sigma equity bubbles in developed countries have reversed the trend, but there have been several previous cases where they developed into 3-sigma or greater super-bubbles: 1929 and 2000 in the US and 1989 in Japan. There were also housing bubbles in the US in 2006 and Japan in 1989. All five of these super-bubbles reversed the trend, with much larger, longer and more painful effects than average.

The United States is currently in the midst of its fourth super bubble in the last 100 years.”

Are we in a market bubble right now? Maybe. Honestly, I don’t know. The problem is that market bubbles only become apparent and recognized once they burst. This is because during the inflationary phase of a market bubble, investors “Not this time.”

As I noted at the time, there are three components to a market bubble.

  1. price
  2. evaluation
  3. Investor sentiment

Market bubbles have existed in the past when investors inflated asset prices above underlying earnings growth rates. Because economic activity produces revenues and profits, valuations cannot exceed the underlying fundamental reality indefinitely.

Interestingly, the 2022 correction has begun the process of reversing that deviation, although investor speculation has brought it closer to its previous peak.

As always, valuation is a function of price and earnings. Thus, deviations in price from a long-term exponential growth trend signal a historical peak. Naturally, when price momentum spikes, investors rationalize why this time around, paying a higher price relative to earnings is justified. Unfortunately, as mentioned above, that rarely works out that way.

As the figure shows, the definition of a market bubble is: “Assets typically trade at prices well above the intrinsic value of the asset, but the prices are not in line with the asset’s fundamentals.”

The important thing is, As mentioned above, Excessive valuations and deviations in prices from long-term norms are due solely to investor psychology.

“Evaluation indicators are really just indicators of current evaluation. More importantly, when a valuation metric is overvalued, it is a better indicator of “investor psychology” and a manifestation of the “greater fool theory.” As you can see, there is a high correlation between our composite consumer confidence index and the S&P 500 stock index over the past year.”

Valuation gives you a reasonable estimate of long-term investment returns. If you overpay today for a stream of future cash flows, it makes sense that future returns will be lower.

So why revisit this topic?

An optimistic group

While ample data suggests economic growth is weakening, investors are once again chasing assets with near reckless abandon: Equity allocations, for example, have skyrocketed as the pursuit of asset market returns replaces logic and underlying fundamentals.

The American Association of Individual Investors’ (AAII) asset allocation index shows a similar trend, with investors increasing their investments in stocks and reducing their investments in cash.

Additionally, extremely low volatility indicates high levels of investor complacency. Historically, when market volatility is low, it is prone to sudden reversals.

Suppose we want to create a composite index of investor sentiment and volatility. (When one is high, the other is low). If that is the case, then current levels would coincide with a short- to medium-term market peak and correction.

Does this mean the market is about to collapse? No. But as Howard Marks previously pointed out:

Investor behavior can help you infer sentiment, which can help you understand how risky a market is, even if it doesn’t tell you for sure which direction it will go. By understanding what is going on, you can gauge the “temperature” of the market.

Remember to buy more when market sentiment is calm and buy less when market sentiment is heated. For example, the ability to execute large volumes of inherently risky trades suggests there is little skepticism among investors. Similarly, when new funds are consistently oversubscribed, it signals enthusiasm.

There is no denying that bullish sentiment is over-proliferated right now. Investors are willing to take risks and overpay relative to underlying valuations to justify their actions. Historically, such actions have been a precedent for markets where expectations outweigh the underlying fundamental realities.

But while this may be true, we should never forget the famous words of John Maynard Keynes:

“The market will remain irrational for longer than you can remain solvent.”

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Managing risk and reward

Whether or not you agree that current market deviations are significant is largely irrelevant. Every investor approaches investing differently. We spend a lot of time studying the current market environment to reduce the risk of catastrophic losses. Does that guarantee that the endeavor will be successful? No. But understanding the risks we are taking on can help us quantify the loss of capital if something goes wrong.

For those approaching or already in retirement, risk management becomes much more important because their investment horizon is shorter than someone much younger. Therefore, they are less likely to recover from short-term market price fluctuations.

There are a few simple steps you can take to prepare.

  • Avoid the “herd mentality” of paying higher and higher prices for no good reason.
  • Do your research and avoid “confirmation bias.”
  • Develop a sound long-term investment strategy that includes a “risk management” protocol.
  • Diversify your portfolio allocation model to include “safer assets.”
  • Control your greed and resist the temptation to make “get rich quick” investments.
  • Don’t get hung up on “what might have been” or “hang on” to past values, as this leads to emotional mistakes.
  • Realize that price inflation won’t last forever — the greater the deviation from the average, the greater the eventual reversal — so invest accordingly.

Increased speculative risk and excessive leverage make markets vulnerable to significant corrections. Unfortunately, the only thing missing isfear” An overly complacent market.

Currently, investors are“Not this time.”

“At this time” It is different only because the variables are different. The variables are always the same, but the outcome is always the same.

When the correction finally comes, the media will say: “No one could have predicted that.”

Of course, hindsight isn’t much help in protecting capital.

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2024/06/04

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