The Look Back Effect exists because the future is always uncertain. Uncertainty makes investors nervous, so they look back a few years — and they look to each other — to decide what to do. This behavior gives rise to The Look Back Effect, when valuation becomes the slave of past performance and consensus.
THERE are two kinds of valuation in the stock market. There’s intrinsic value, a metric like Brock Value, which tells you where the market should be trading, and then there’s the actual valuation, which is set by supply and demand.
PYi – the ratio of price over GDP, adjusted for interest rates – measures supply and demand. When the market is like a boiling kettle, PYi is high. When investors have been jilted and are afraid of stocks, PYi is low.
When you map PYi against the trailing returns of the S&P 500 index, the Look Back Effect reveals itself. It clearly says investors decide what to do based on what other investors have decided. In other words, investors synchronize their expectations with past performance and with each other.
In good times, after several years of high returns, the Look Back Effect seems to tell investors that what goes up, must go up. Fear of missing out results in very high valuations. In extreme cases, every 30 to 40 years, investors indulge in an orgy of speculation that pushes stocks to absurd levels.
In the times of trouble that always follow, past performance is discouraging, embarrassing. Sellers look back and feel the need to cut their losses. Buyers look back and hesitate. A newfound value-consciousness emerges. But even in the presence of supportive fundamentals like dividends or free cash flow, expectations can sink for a long time.
Observations of the PYi Ratio
The PYi ratio clearly shows three eras of overvaluation, with peaks in 1929, 1969 and 2000. The corresponding lows were in 1942, 1978 and 2009. You may see the tracing of a giant S in the fifty years between 1929 and 1979, and another undulation between 1969 and 2009. Three observations follow.
First, valuation is stable only about half the time, when it oscillates about its median. These are the times when you might believe the market is efficient.
Second, when valuation leaves its normal range, it moves persistently to an extreme. Common sense takes a holiday, and doesn’t come back for a long time.
The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant.
Third, exceedingly high valuation ends abruptly. And once it begins to collapse, high valuation eventually leads to low valuation. It takes about a decade to move from stupidly high valuation to idiotically low valuation, and two or more decades after that to reach a new peak. That’s because each generation of investors remembers its mistakes and it takes a new generation to repeat them.