Managing Risk Is More Crucial Than Ever Amid Bullish Exuberance, Complacency
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In 2022, we discussed the market’s deviations from long-term growth trends. That discussion centered on Jeremy Grantham’s commentary about market bubbles.
“
Are we currently in a market bubble? Maybe. Honestly, I have no idea. The problem is that market bubbles are only evident and acknowledged after they pop. This is because, during the inflation phase of the market bubble, investors rationalize why
As we noted then, there are three components of market bubbles:
When investors bid up asset prices that exceed underlying earnings growth rates, market bubbles were previously present. Since economic activity generates revenues and earnings, valuations can not indefinitely exceed the underlying fundamental realities.
Interestingly, the correction in 2022 started the reversion process of that deviation. However, investor speculation has since pushed that deviation near its previous peak.
Real S&P 500 Deviation From Growth Trends
As is always the case, valuations are a function of price and earnings; therefore, deviations in price from the long-term exponential growth trend have marked prior peaks. Unsurprisingly, when price momentum increases rapidly, investors rationalize why overpaying for earnings is justified this time. Unfortunately, as shown, such has rarely worked out well.
Valuations vs Deviations From Growth
As the chart shows, and the definition of a market bubble states,
Crucially, as previously discussed, excess valuations and price deviations from long-term norms are solely a function of investor psychology.
Consumer Confidence Vs Trailing Valuations
What valuations do provide is a reasonable estimate of long-term investment returns. It is logical that if you overpay for a stream of future cash flows today, your future return will be low.
So, why are we rehashing this topic?
An Optimistic Bunch
While sufficient data suggests that economic growth rates are weakening, investors are again chasing assets with near reckless abandon. For example, investor allocations to equities are rising sharply as chasing asset market returns displaces logic and underlying fundamentals.
Household Equity Allocations vs S&P 500
The American Association Of Individual Investors (AAII) allocation measures suggest the same, with investors increasing exposure to equities and reducing cash.
AAII Investor Allocaitons Stocks, Bonds, & Cash
Furthermore, extremely low levels of volatility suggest a high level of complacency among investors. Historically, low levels of market volatility tend to reverse suddenly.
VIX vs S&P 500
Suppose we create a composite index of investor sentiment and volatility In that case, current levels align with short- to intermediate-term market peaks and corrections.
Sentiment to Vix Ratio vs S&P 500
Does this mean the market is about to crash? No. However, as Howard Marks previously noted:
Currently, there is little denying the more excessive bullish sentiment that abounds. Investors are willing to take on risk, overpay for underlying valuations, and rationalize their actions. Historically, these actions have been the precedents of markets where expectations exceed underlying fundamental realities.
However, while that may indeed be the case, we must never forget the famous words from John Maynard Keynes:
Managing Risk And Reward
Whether you agree that current market deviations are important is mostly irrelevant. Every investor approaches investing differently. We spend much time researching current market environments to reduce the risk of catastrophic losses. Does that guarantee we will be successful in that endeavor? No. However, understanding the risks we are undertaking helps us quantify capital destruction in case something goes wrong.
Managing risk is far more crucial if you are nearing or have entered retirement. The reason is that your investment horizon is shorter than that of those much younger. Therefore, you are less able to recover from short-term market repricings.
There are some simple steps you can take to prepare yourself.
The increase in speculative risks and excess leverage leaves the market vulnerable to a sizable correction. Unfortunately, the only missing ingredient is the catalyst that brings “ into an overly complacent marketplace.
Currently, investors believe “
is different only because the variables are different. The variables always are, but outcomes are always the same.
When the eventual correction comes, the media will tell you,
Of course, hindsight isn’t very useful in protecting your capital.
