Treat the valuation climate as climate and implied-volatility extremes as weather

At horizons of about 10 to 20 years, market outcomes were treated as principles-driven by lasting fundamental drivers rather than as random month-to-year fluctuations. The first job was to name the valuation-climate: the extended rise or fall in the earnings multiple that, over roughly five to twenty-five years, separates above-average from below-average secular stretches.

Three building blocks, one multiple

Equity returns were decomposed into three building blocks only: earnings growth, change in the price-to-earnings multiple, and dividend yield. That return-decomposition kept the long-horizon question on whether the multiple was still expanding or already compressing.

Inflation relative to price stability was identified as the main secular driver of the multiple. Low, stable inflation was associated with rising valuations. Higher inflation or deflation was associated with falling valuations. The inflation-anchor is the principle that a fair multiple depends on whether inflation is low and stable, elevated, or deflationary.

Secular-regime and the nested cyclical-regime

A secular-regime is a multi-year to multi-decade market climate defined by the direction of the price-to-earnings multiple rather than by the last swing. Secular bull climates were defined as extended stretches of a rising multiple, with four such episodes cited in the prior century. Secular bear climates were defined as stretches that start with a high multiple and then compress, with five such episodes cited.

Inside that secular climate, shorter cycles lasting months, quarters, or a few years were attributed to trend, psychology, momentum, and supply-demand rather than to the long-horizon valuation principle. A cyclical-regime is that shorter nested phase, lasting months to a few years and driven more by trend, psychology, momentum, and flows.

Knowing whether the multi-year climate resembled the 1980s and 1990s rising-multiple stretch or the subsequent 17-year choppy, nondirectional stretch was said to change how shorter-horizon trading would be approached. That is regime-dependent-style: shorter-horizon tactics should change when the multi-year climate is a rising-multiple stretch versus a choppy, compressing-multiple stretch.

Where the multiple stood in the snapshot year

The 2017 snapshot placed the normalized multiple near 30, below a 2000 peak above 40, and treated a further multi-year doubling or tripling of that multiple as an unsustainable path from that starting level. A typical historical multiple peak in the low-to-mid 20s was used as the low-inflation fair-value band. A reading near 30 was described as about 20 percent above that band, rather than as a comparison with the long-run average multiple of 15 to 16 that corresponded to century-average inflation above 3 percent.

Implied-volatility-complacency as weather

In the interview year, option-implied volatility printed below 10 on seven sessions, equal to half of all such sessions since that index began in 1990, while trailing realized volatility sat in the lowest 4 percent of observations since 1950. Implied-volatility-complacency is unusually low option-implied volatility used as a forward-looking sign that risk is being priced cheaply.

The combination of low implied volatility, high complacency, and elevated valuation was framed as a shorter-term vulnerability marker for a change in the cyclical-regime, not as a stand-alone directional prediction.