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If you need to reduce risk, do it now
By Advisor Perspectives
The single most important thing for investors to understand here is how current market conditions differ from those that existed through the majority of the market advance of recent years. The difference isn’t valuations. On measures that are best correlated with actual subsequent 10-year S&P 500 total returns, the market has advanced from strenuous, to extreme, to obscene overvaluation, largely without consequence.
The difference is that investor risk-preferences have shifted from risk-seeking to risk-aversion. That may not be obvious, but in market cycles across history, the best measure of investor risk preferences is the behavior of market internals, as measured by 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 observations on that are not new at all. Extreme overvaluation coupled with deterioration in market internals was the same set of features that allowed us to avoid the 2000-2002 and 2007-2009 market collapses. Given our success in prior cycles, why did we stumble in the advancing half of this one? The fact is that in 2009, I insisted on stress-testing our methods of classifying market return/risk profiles against Depression-era data, setting off a sequence of inadvertent but related challenges in the recent cycle, which we fully addressed last year. I’ve detailed the central lessons in nearly every weekly comment since mid-2014. The full narrative is detailed in our 2015 Annual Report. As I observed in the accompanying letter:
If there is a single lesson to be learned from the period since 2009, it is not a lesson about the irrelevance of valuations, nor about the omnipotence of the Federal Reserve. Rather, it is a lesson about the importance of investor attitudes toward risk, and the effectiveness of measuring those preferences directly through the broad uniformity or divergence of individual stocks, industries, sectors, and security types. In prior market cycles, the emergence of extremely overvalued, overbought, overbullish conditions was typically accompanied or closely followed by deterioration in market internals. In the face of Fed induced yield-seeking speculation, one needed to wait until market internals deteriorated explicitly. When rich valuations are coupled with deterioration in market internals, overvaluation that previously seemed irrelevant has often transformed into sudden and vertical market losses.
If you review my concerns in recent years, prior to mid-2014, you’ll notice that they focused on the extreme nature of the “overvalued, overbought, overbullish syndrome” that had emerged. Examining these syndromes across history, these overextended conditions were typically accompanied or quickly followed by deterioration in market internals, and then by vertical air-pockets, panics or crashes. Because of that regularity (which was picked up by the methods that emerged from our stress-testing efforts), we shifted immediately to a defensive outlook when those overvalued, overbought, overbullish syndromes emerged. The problem, in this cycle, was that the Fed aggressively and intentionally encouraged persistent yield-seeking speculation regardless of valuation extremes. One needed to wait until market internals deteriorated explicitly before taking a hard-negative outlook on the market – a requirement (“overlay”) that we imposed on our methods last year.
It may not be obvious that investor risk-preferences have shifted toward risk aversion. It’s