The future makes investors nervous, so they rely on two things to find the strength they need to make tough decisions: the market’s recent track record, and signs of unanimity. 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.
For example, after they see a progression of rising returns, investors want to leap into the light. And then as they do, legions more join in. In extreme cases, every 30 to 40 years, investors indulge in an orgy of speculation that pushes stocks to absurd levels.
In the hard times that always follow, past performance is dismal. The outlook is discouraging. Buyers look around and see little reason to rush into the market. Sellers look back and feel ashamed of themselves for not selling sooner. Bargain-hunting comes back into style.
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 market theories evolve only one generation of investors at a time.