Is the New Normal of ever-higher stock valuations sustainable, or will low volatility lead to higher volatility, and intervention to instability?
Though we’re constantly reassured by financial pundits and the Federal Reserve that the stock market is not a bubble and that valuations are fair, there is substantial evidence that suggests the contrary.
The market is dangerously stretched in terms of valuation and sentiment, and it does not accurately reflect fundamentals such as earnings and sales growth.
Why do we care? If we own no stocks in a retirement or other account, we don’t care; it’s mere background noise. But if we’re exposed to the gyrations of the stock market in any way, we should care, because those who sell near the top before the market drops preserve not just their initial capital, but their winnings from the 5+-year bull market. Those who fail to sell risk losing not just their gains, but quite possibly a material chunk of their initial capital.
Another reason to care is that those who bet the market will decline in a trend-reversal profit handsomely, just as those who buy at the bottom of a decline profit handsomely from the trend reversal from down to up.
Let’s start with the most fundamental truth: nobody knows the future. If any technique of prognostication worked every time, anyone with three 100% accurate forecasts in a row could turn $5,000 into $100,000 in three trades using options (or futures contracts). A decent rise or drop will triple an option bought before the move:
$5KÂ -> $15K
$15KÂ -> $45K
$45KÂ -> $135,000
That few manage the apparently simple task of making three accurate predictions in a row (and being confident enough in the technique to leave all the chips on the table) is powerful evidence that no such technique works consistently enough to last even three trades.
That said, the benefits from being correct even once are powerful enough to make it worthwhile to pursue increasing the odds in our favor—even if the odds will never be 100% in our favor.
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