Ok, so having dispensed with the last important data point of the week, we can get back to talking about how this market is stretched to the proverbial breaking point.
To say that’s well-worn territory is to state the obvious.
But that’s the thing: the more ubiquitous the stretched market meme gets, the more it underscores how incredibly stupid some folks are going to feel when they’re caught wrong-footed.
The “writing” isn’t just “on the wall” at this point, it’s scrawled in blood in giant letters like that famous scene from 28 Days Later:
So the bad news is that an Albert-Edwards-style risk asset apocalypse is probably just around the corner, but the good news is that if you’ve got the balls to hang on until the tide turns, history says you’re in for still more gains.
Consider the following from a Goldman note out this morning…
It is hard not to worry that things are a little ‘too good’.
With sentiment still elevated, market valuations at record levels, and labor markets on track for levels that should soon begin to look overheated, this expansion is clearly ‘late cycle’, or as our colleagues in Portfolio Strategy like to describe it, the ‘optimistic’ stage of the expansion when sentiment has finally run out ahead of reality. When valuations are high and everything is going great, that is usually a good sign that it may be time to lighten up on risk.
But market timing is tricky.
Exhibit 1 provides a reminder of just how tricky. This table shows that, even if one knew with perfect foresight that the end of the cycle was coming in 24 months, it would be hard to justify scaling out of risk just yet. To construct this table, we use NBER recession dates to segment history into expansions and recessions. We then subdivide expansions by identifying the final two years of the expansion: the one-year periods beginning exactly two years and one year before the onset of the recession.
We next characterize the distribution of returns within each of these four segments. We are particularly interested in whether the last two ‘late-cycle’ years of the expansion are characterized by lower returns, higher risk, or higher downside risk. The interest in downside risk is motivated by the fact that late-cycle financial markets generally tend to become ‘priced for perfection’, leaving them vulnerable to over-valuations and hence sharp market corrections.
This intuition is only partly confirmed in the data. For equities, the first conclusion to draw from Exhibit 1 is that ‘two years is too early’. On the contrary, in the one-year period falling two years prior to recessions, equities have historically had higher returns than in the expansion up to that point, and these returns have been realized with lower variance and less downside risk (as measured both by the skew statistic as well as by the 10th percentile of the return distribution). Within 12 months of recession, however, cracks begin to show. Average equity returns fall from 0.92% for the prior year to just -0.05%. While better than the -0.55% average monthly returns in recession, this suggests that 12 months is the horizon over which markets begin to anticipate recession. The 12 months ahead of recession are also characterized by rising volatility and downside risk, both of which jump materially with actual onset of recession.
Or, summed up in one visual…