It is a good idea to read and understand this entire article, grasp the nuances, and study the graphs. From John P. Hussman at hussman.net:
Over the years, I’ve observed that overvalued, overbought, overbullish market conditions have historically been accompanied by what I call “unpleasant skew” – a succession of small but persistent marginal new highs, followed by a vertical collapse in which weeks or months of gains are wiped out in a handful of sessions. Provided that investors are in a risk-seeking mood (which we infer from the behavior of market internals), sufficiently aggressive monetary easing can delay this tendency, by starving investors of every source of safe return, and actively encouraging further yield-seeking speculation even when valuations are obscene. Once investors become risk-averse, as deteriorating market internals have suggested in recent months, vertical declines much more extreme than last week’s loss are quite ordinary.
The way to understand the bubbles and collapses of the past 15 years, and those throughout history, is to learn the right lesson. That lesson is not that overvaluation can be ignored indefinitely – we know different from the collapses that have regularly followed extreme valuations. The lesson is not that easy monetary policy reliably supports stock prices – persistent and aggressive easing did nothing to keep stocks from losing more than half their value in 2000-2002 and 2007-2009. Rather, the key lesson to draw from recent market cycles, and those across a century of history, is this:
Valuations are the main driver of long-term returns, but the main driver of market returns over shorter horizons is the attitude of investors toward risk, and the most reliable way to measure this is through the uniformity or divergence of market internals. When market internals are uniformly favorable, overvaluation has little effect, and monetary easing can encourage further risk-seeking speculation. Conversely, when deterioration in market internals signals a shift toward risk-aversion among investors, monetary easing has little effect, and overvaluation can suddenly matter with a vengeance.
To continue reading: Risk Turns Risky
