Elevated equity valuations are not necessarily a call for a defensive posture. Historically high valuations relative to fair value can persist, leaving stocks to trade at a rich premium relative to average historical valuation metrics for an extended period of time. The substance that allows stocks to defy gravity (resist mean regressive tendencies) is the high risk propensity/tolerance of market participants. If investors are willing to bare risk in spite of high valuations, market pressure to return to historically normal valuation levels will be limited. Of course market perception is quite fickle and can change on a dime.
Despite high valuations, current investor propensity to bare risk is still high as seen through rising equity prices (2005 market action notwithstanding), tight credit spreads, a blistering housing market, etc. The risk propensity/valuation interplay is something that John Hussman regularly point out in his weekly market comment. According to Hussman:
“Though the recent selloff in the major indices is certainly what one might have expected from an overvalued, overbullish, overbought market, it does not follow that stock prices are inherently poised to fall apart. Again, valuation has everything to do with long-term returns, but precious little to do with short-term ones. As long as investors have a robust willingness to accept risk, there can be very little pressure on the market to decline toward more historically normal valuations. So in addition to valuations, we have to consider the quality of market action. The greatest plunges in market history have always emerged from overvalued markets in which investors have recently become skittish toward risk, as evidenced by market action.”
Overall, market internals have not deteriorated enough to warrant complete risk aversion. Although, when mega-stalwarts like EBAY forfeit nearly $20 after missing consensus earnings estimates, you start to worry. Ebay’s drop clearly signals first, that investors are beginning to display at least some semblance of risk aversion, and second, that the market is currently priced for perfection. Ebay’s dramatic decline delivered a clear warning shot. Rarely do markets exert upside pressure when market leaders or high relative strength issues buckle. Be careful out there – the market has coughed up a valuable informational nugget – and it’s not good.
--UK
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