Yuval,
Thank you for sharing those interesting references. I've been reflecting on how to best answer your question, and I often like to start by considering the base case and adjusting those odds with additional information. Of course, what we mean by "base case" can be debated, but I think there are two straightforward ways to approach it:
- Over the last 24 years, my benchmark had negative returns in 8 out of 24 years, giving odds of 1:2 for a down year.
- By my count (and this is open to debate), since 1994, the FED has had five tightening cycles, resulting in one successful soft landing. So, the historical odds of a soft landing are 1:4.
Combining these, I’d estimate the odds of a down year as roughly 1/2 × 4/1, or 2:1 against us having a good year next year. This approach borrows from Bayesian reasoning: starting with base case probabilities and updating them as we gather more information.
I do think these two base cases are independent enough to multiply, or at least close enough to make it useful for framing probabilities. And even if one questions this, the conclusion that the odds are not better than 1:2 was an eye-opener for me. It reinforces the idea that the likelihood of a drawdown in the next four years is high—at least for my benchmark.
Of course, everyone should use a benchmark that aligns with what they’re doing. Some might prefer the cap-weighted SP500 or an equal-weighted version, as long as it has some relationship to their strategy.
So yes, I share your concern. That being said, timing is everything. It wouldn’t be impossible for us to see markets go parabolic first, pushing valuations even higher. The drawdown might not happen in 2025—it could be a great year before things turn.
BTW, using the CAPE in this analysis, as Geov does here, would also be a good idea in my opinion: No, the Market is NotOvervalued Relative to Its Past. I think this is clearly not independent of what the FED is doing, and even then, it doesn’t give us clear odds for next year. But Geov makes a good point, and it suggests a drawdown in the next few years may be even more likely—though quantifying its effect is challenging. Others may not think the CAPE is reliable and might use another metric to adjust the odds.
I’ve been known to be exactly wrong about these things before, but I appreciate the interesting topic and discussion. Thank you again for raising it!
Jim