“History never repeats itself, but it does often rhyme.” – Mark Twain
Introduction: Drawing Lessons from the Rhymes of Financial History
The stock market often follows familiar patterns and themes, even though each era is unique. By studying past market events, investors can gain insights into the future and make more informed investment decisions. The rhymes of history can manifest as economic cycles, speculative bubbles, or the psychological behaviors of investors. While the specific catalysts may change, the underlying human emotions and market dynamics remain remarkably consistent.
In the summer of 2023, we witnessed a breakdown in the traditional relationship between stocks and treasury yields, with equities continuing to rise despite rising interest rates. This anomaly can be attributed to the concentrated performance of a select few mega-cap tech companies. However, as long-duration treasury yields reached new highs, the stock market experienced a local top and declined by nearly 8%. These market dynamics are reminiscent of the past, and investors need to pay attention.
Understanding the Surge in Long-Duration Treasury Yields
Over the past 18 months, treasury yields have surged as the Federal Reserve tightened its monetary policy to combat inflation. With the Fed’s rate hikes and reduction of its balance sheet assets, long-duration treasury bonds have experienced a steep decline. This tightening cycle has created a tightening of financial conditions, signaling slower economic activity. The US treasury yield curve has rapidly uninverted, historically a precursor to economic recessions. The fragility of the financial system and the potential for a hard landing in the economy are concerns worth noting.
In his recent address, Federal Reserve Chair Jerome Powell acknowledged the surge in long-duration treasury yields and highlighted various theories that could explain this phenomenon. Powell admitted that demand for treasuries and bond prices are influenced by multiple factors, making it difficult to pinpoint a single cause. This lack of control by the Fed over long-term yields raises concerns and suggests that the trend may continue.
The Simple Math Behind Stock Valuations
Treasury bond yields serve as the risk-free rate in the investing world. In a normalized environment, equities typically offer a premium of 2-3% on top of this risk-free rate. With long-duration yields reaching ~5%, the S&P 500 should ideally command an earnings yield of 7-8%. However, the market is currently trading at a forward price-to-earnings ratio of 19x, well above these levels. Based on this analysis, the S&P 500 is overvalued and could be due for a correction.
Considering both valuation and technical perspectives, the S&P 500 could potentially drop by 25-50% from its current levels. The market is displaying similarities to the year 1987, which experienced a crash known as “Black Monday.” While we cannot predict whether history will repeat itself, it’s important to acknowledge the risks and prepare for a range of possible outcomes.
Are We Headed for a Crash?
Technical indicators signal a potential breakdown in the stock market. The S&P 500 is testing critical support levels, and a bearish scenario could lead to a crash similar to that of 1987. However, market sentiment and seasonality suggest a potential year-end rally. The coming months will be crucial in determining the market’s direction.
Conclusion: Learn from History and Prepare for the Uncertain
The rhymes of financial history provide valuable insights and lessons for investors. While a crash similar to 1987 may or may not occur, the current economic and financial conditions warrant caution. The valuation of the S&P 500 suggests a significant correction is possible. It is prudent for investors to consider a range of possible outcomes and adjust their investment strategies accordingly.
In light of this analysis, it is recommended to approach the market with caution and consider the potential risks associated with current valuations. While a bounce in the market may occur in the short term, the medium-term risk/reward ratio suggests a cautious approach.
