I recently finished Howard Marks’ Mastering the Market Cycle. It was a great book from an industry veteran who has seen a thing or two during his six decades in the business. While there is much wisdom in the book, the part that continues to stand out to me is the chapter on how to cope with market cycles. The author states:

“The risk in investing doesn’t come primarily from the economy, the companies, the securities, the stock certificates or the exchange buildings. It comes from the behavior of the market participants. So do most of the opportunities for exceptional returns.”

In other words, it’s our perceptions and resultant actions as investors that are the sources of real risk in investing. Of course, our reactions to unexpected events are part of the behavior to which the author refers. We can’t predict when the unexpected events will occur let alone what they actually will be. So our focus should be on what we can know and control. Understanding the market environment we are in at a given point in time is critical. Investor perceptions and behavior over a market cycle change and if we’re not careful we may not pick up on important shifts in sentiment and valuation. To that end, the author highlights two important components to understanding where we stand in a given market cycle:

1. Gauge valuations: if valuations are not out of line with history then the market is unlikely to be highly extended in either direction. How are things priced?
2. Be aware of what’s going on around us, and in particular of investor behavior. How are investors around us behaving?

Simply put: how are things priced and how are investors around us behaving?

Let’s take a look at where we are today in the context of the above two points.

Valuation

I highlighted the CAPE ratio in last week’s post, demonstrating that relative to the last 40 or so years the current CAPE ratio doesn’t appear to be at extreme levels. The flaw with my analysis is it doesn’t necessarily represent the “right” way to evaluate current valuations and the amount of risk embedded in prices right now. It was merely another lens through which to view the popular valuation metric.

Taking a look at a metric that is less subjective, the Wilshire 5000 market capitalization relative to GDP, we see that aggregate stock market capitalizations (stock price multiplied by the number of shares outstanding) are at an all time high versus GDP as of the third quarter of this year. Extrapolating out to today, using the Conference Board’s estimate for 4Q20 GDP growth and the average Wilshire 5000 market cap for the fourth quarter-to-date, the ratio moves even higher. Extrapolating further out, assuming we could return to the level of peak GDP attained in the fourth quarter of 2019 and again using the fourth quarter-to-date market cap for the Wilshire 5000, the ratio dips ever so slightly. We are well above the 2000 peak. For us to return to the peak ratio level reached in 2000 at the current market cap level, nominal GDP would need to grow over 27% from the third quarter seasonally adjusted annualized level. Assuming a 4% annualized nominal growth rate in GDP, it would take over six years to get to that level of GDP. I know the market is a discounting machine but six years out is an eternity in the economy and investing markets. On this metric, stock market valuation is at stratospheric levels. It’s just one metric that provides valuable context but again isn’t necessarily the “right” lens through which to view the market. Importantly, elevated valuation levels don’t mean the market is going to crash any time soon. It simply means the risk of below average future returns is higher as is the risk of a sharp drop in asset prices, whenever prices actually start to fall (the higher you go the harder you fall).

Sentiment

I came across the chart below the other day, courtesy of a blog post by Jesse Felder. To quote Mr. Felder directly as it relates to the sentiment chart,

“It was almost a year ago that I highlighted the fact that Rydex traders were getting very bullish again. To be clear, I’m referring to the Rydex Ratio, “or the measure of Rydex traders’ assets in bear funds and money market funds relative to their assets in bull funds and sector funds.” As of last week, this ratio fell to its lowest level on record. In other words, these traders are now positioned more aggressively bullish than ever before, including the heady days of the dotcom mania 20 years ago.”

Putting this into layman’s terms, when professional traders are cautious they’re invested more heavily in investments that have a low likelihood of losing money (money market funds) and/or in investments that are supposed to do well if the stock market goes down (bear funds). When traders are more optimistic and aggressive they’re invested more heavily in stocks and other assets that do well when the stock market goes up (bull funds and sector funds). When positive sentiment is at extreme levels, the risk of a sharp drop in prices is again very high whenever prices start to fall. We can’t predict when the trend in prices will inflect and a downtrend will emerge, but we know that when it happens the risk that the downtrend in prices will be severe is higher than it would be normally. As a reminder, it doesn’t mean the downtrend will end up being severe. At these levels there’s a higher probability the downtrend will be more severe than it would otherwise be expected.

Numerous sentiment indicators exist. There’s nothing to say the above indicator is any better or worse than other indicators. The VIX is another good sentiment indicator to track. The index has almost made the roundtrip back to pre-COVID levels. If the VIX is in a downtrend, stock prices likely aren’t going lower any time soon, all else equal. On the chart below, the best time to have been aggressively overweight stocks was when the index was at its peak. Of course that was likely the most difficult time to overweight stocks too.

Several important indicators are flashing warning signs. The author counsels readers to be defensive in environments like these, which makes sense given the risks that exist. Very sound advice based upon years of experience but difficult to strictly follow in an environment where monetary and fiscal policies are extremely loose and aren’t expected to tighten any time soon. Balancing the current downside risks with the upside opportunities hasn’t been this challenging during most of our lifetimes. It should make for adventurous times ahead.

Photo by Jeremy Thomas on Unsplash