Bear markets can take time to unfold and present countless opportunities for investors to lose capital. Each market bounce can lead to investors buying at higher prices, only to later face the reality of selling at a loss.
The prominent U.S. stock market indexes reportedly reached a temporary bottom in the fall of 2022, followed by a remarkably vigorous rebound. This recovery has instilled new confidence among investors—possibly at the worst possible time.
Many analysts have erroneously interpreted this bear market recovery, dubbed a “sucker’s rally,” as the dawn of a new bull market. Following a strong performance in January, discussions surrounding a potential bull market have proliferated.
Perhaps they’re right; perhaps this selloff was merely a consolidation phase, and the major indexes will soon eclipse their previous all-time highs. However, we approach that notion with skepticism.
Billionaire investor Jeremy Grantham, co-founder of GMO, recently shared insightful commentary regarding the future trajectory of the S&P 500 in his 2023 outlook letter, After a Timeout, Back to the Meat Grinder!, published on January 24. Grantham stated:
“While the most extreme froth has been wiped off the market, valuations are still nowhere near their long-term averages. My calculations of the trendline value of the S&P 500, adjusted for growth and expected inflation, indicate it could reach about 3,200 by the end of 2023. I believe it is three times more likely to hit that trendline and spend some time below it this year or next.”
As of Thursday’s close, the S&P 500 sat at approximately 4,012, which means achieving 3,200 would require a 20% drop. What should we make of this?
Reversion to the Mean
While the S&P 500 isn’t as egregiously overvalued as it was 16 months ago, it remains significantly above historical norms. The cyclically adjusted price-to-earnings (CAPE) ratio, calculated by Shiller, currently stands at 29.14, compared to a historical mean of 17.
Unless there has been a fundamental shift in market dynamics—rendering past averages irrelevant—the S&P 500 may still have substantial ground to cover before it stabilizes. It’s likely that this decline could coincide with a financial panic, prompting a surge of sell-offs. Grantham even highlighted that a 50% drop from current levels is well within the realm of possibility.
“Even in the most dire scenario of a 50% decline, we’d settle just below 2,000 on the S&P, which would still be about 37% undervalued compared to the trendline. This deviation would be less drastic than the overpricing of over 70% we witnessed at the end of 2021. Hence, it’s important to keep in mind that such a downturn is entirely plausible.”
If you are unfamiliar with Jeremy Grantham’s work, he’s renowned for accurately forecasting market bubbles throughout his career, including the Japanese Nikkei bubble in the late 1980s, the dot-com bubble in 2000, and the housing bubble in the mid-2000s.
His approach is profoundly pragmatic, focusing on a core financial principle of “reversion to the mean.” This tenet holds that all assets will eventually return to their average historical valuations after periods of exuberance or despair.
Think Again
On February 21, the stock market experienced a sharp decline, with the Dow Jones Industrial Average, S&P 500, and NASDAQ falling by 2.06%, 2.00%, and 2.50%, respectively. While this may seem insignificant, it serves as a stark reminder of the underlying risks still present in today’s market valuations.
Moreover, rising treasury yields have created a more attractive environment for holding bonds, making stocks appear increasingly risky. For instance, the yield on a 12-month treasury note has surpassed 5%. Could the S&P 500 realistically increase by 5% over the next year?
It certainly could rise, potentially even surpassing that figure. However, based on Grantham’s analysis, it could just as easily suffer a decline of 20% or even 50%.
Each individual must decide at what point the risk associated with stocks outweighs the rewards of bonds, influenced by their risk tolerance and investment horizons. For many, accepting a 5% yield—despite it being below the current inflation rate—may seem more appealing than the gamble of incurring a possible 20% loss in equities.
As yields rise amid an overvalued stock market, the lure of bonds becomes stronger. Eventually, investors may begin reallocating more of their portfolios away from stocks and into bonds, leading to further declines in stock indexes.
This transition is part of a natural economic cycle. The correlation between interest rates and asset prices isn’t complicated: tighter credit typically results in lower asset prices, while looser credit fosters higher asset prices.
For two decades, artificially low interest rates—enabled by the Federal Reserve—have inflated a massive stock market bubble. If you believe the decline from January to October 2022 was sufficient to eliminate prior excesses, it may be time to rethink that notion.
Fear and Greed with a Roll of the Dice
Warren Buffett, in his 1986 Berkshire Hathaway shareholder letter, shared a timeless insight:
“Occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. The market aberrations they create will be equally difficult to forecast, in terms of duration and intensity. Therefore, we never try to predict when fear or greed will arrive or depart. Rather, our goal is more modest: we strive to be fearful when others are greedy and greedy only when others are fearful.”
This recommendation embodies a classic contrarian approach to investing, acknowledging how market psychology drives price fluctuations. Investors tend to be spurred by greed during rising markets, driving prices further up, while fear prevails during downturns, often prompting sales at market lows. Buffett advocates for aligning with the opposite sentiment of the crowd.
Yet, while this philosophy is compelling, execution is more challenging. The U.S. stock market showcased rampant greed in 2021; astute investors capitalized on this by selling before the peak and dodging the ensuing fallout.
But did they re-enter the market when it dipped in October 2022? Some did, while others did not. How can one accurately gauge when the market is driven by fear vs. greed?
CNN Business offers a Fear & Greed Index for those interested. This index compiles seven different indicators, including market momentum, stock price strength, stock breadth, put and call options, junk bond demand, market volatility, and safe harbor demand.
The index assigns equal weight to each indicator, generating a score from 0 to 100, where 100 signifies maximum greed and 0 represents maximum fear. Currently, the index registers at 63, placing it squarely in the greed category.
In summary, Grantham suggests that the stock market has significant ground yet to cover to realign with its historical averages. Additionally, the advantages of treasuries are beginning to overshadow the risks associated with stocks. Buffett’s advice cautions that one should be fearful when others succumb to greed. Presently, the Fear & Greed Index is decidedly positioned within the greed range.
So, what should you do?
You could take a chance, purchase shares of Tesla, and hope for a positive outcome. You wouldn’t be alone; as of last week, retail investors had funneled $9.7 billion into Tesla this fiscal year.
However, we recommend a more cautious approach—perhaps lightening your equity positions and taking a break from the market for a few months.
[Editor’s note: A comprehensive investing strategy should include considerations of geopolitical factors. To that end, I have just completed a unique Special Report titled “War in the Strait of Taiwan? How to Exploit the Trend of Escalating Conflict.” You can access it here for less than a penny.]
Sincerely,
MN Gordon
for Economic Prism
Return from Fear and Greed with a Roll of the Dice to Economic Prism
