Earlier this year I wrote a series of educational notes on using valuation signals to help navigate market cycles, and after a couple of conversations and comments I got to wondering what it would look like if you showed the average path the stock market took around valuation-extreme tops and bottoms.
As a point of clarity, first I want to compare and contrast two types of market peaks.
The August 2000 peak was a classic valuation-extreme top, a bubble; clear excess and extreme expensive valuations… just waiting to be popped (by rising interest rates).
The October 2007 peak by contrast was *not* a valuation-extreme top. Across a number of valuation metrics the market looked reasonable, even cheap e.g. on a forward PE basis. Instead, that peak was the product of rising rates triggering an economic downturn and ultimately a financial crisis.
To be fair, there were pockets of overvaluation in sectors and in other countries (e.g. emerging markets), but the S&P500 itself, was not expensive back in 2007.
But back onto the chart and the study details...
I basically subjectively singled out extremes in the Shiller CAPE ratio and my own quant valuation indicator to identify 8 major valuation-extreme (expensive) market peaks, and 12 major valuation-extreme (cheap) troughs over the period 1910 to 2024 (using the Shiller data). For example, the dot com bubble peak of Aug 2000 was included, but the Oct 2007 peak was not included (however the subsequent March 2009 bottom *was* included as it showed up strongly as a valuation-extreme bottom).
The resulting picture is displayed below.
Some thoughts and observations:
i. After peaking the market typically traded higher n the years afterward vs the years before the peak, while after bottoming the market typically traded slightly lower than the years before.
ii. In the lead-up to market peaks the market followed a relatively orderly path (a “straight line“), heading into valuation-extreme bottoms though the decline started slowly at first and then falls at a faster rate into the trough.
iii. Post-peak the declines were very rapid at first and then the rate of decline slows; similarly, valuation-extreme bottoms typically saw a sharp and significant immediate rebound before a progressively slower rate of increase.
Key Takeaways and Conclusions
a. Heading into market troughs you basically want to reduce exposure as early as possible (before declines accelerate), but equally you want to raise exposure and get back in as soon as it looks like the bottom is in (when valuations become extreme cheap) to make the most of that initial rapid rebound phase.
b. Heading into market peaks the ride can be deceptively smooth and rewarding, but perversely when things turn the pace of decline is most rapid during the initial phase, and you might not be able to just gradually scale out. So it either requires pulling back exposure and sacrificing upside, or thoughtful and smart hedging and diversification strategy to help guard against sudden downturns.
$S&P 500(.SPX)$ $SPDR S&P 500 ETF Trust(SPY)$ $E-mini S&P 500 - main 2412(ESmain)$ $NASDAQ(.IXIC)$ $NASDAQ 100(NDX)$ $Invesco QQQ(QQQ)$ $E-mini Nasdaq 100 - main 2412(NQmain)$ $DJIA(.DJI)$ $GLOBAL X DOW 30® COVERED CALL ETF(DJIA)$
Image
https://x.com/Callum_Thomas/status/1838036819956670920
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