Even though we are on the precipice of a potential all-out war in the Middle East, which could cause a majorshock and trigger global recessions, US stock valuation ratios are near all-time highs, and implied equity risk premiums are near all-time lows.
Market prices reflect the opinions and emotions of a marginal buyer and a marginal seller. We know that all investors evaluate risks differently and they even evaluate risks differently at different times. To understand what sort of risks are being accounted for in market prices one needs to understand who the marginal buyers and sellers are and what their tendencies are concerning the evaluation of risks at that particular time.
Another factor that comes into play could be called “the boy who cried wolf”. In the latter stages of a bear market, there will already have been various instances in which feared outcomes did not materialize. Whereas such fears were discounted earlier in the bull market , they tend to be ignored late in a bull market.
The second major group of value-insensitive and risk-insensitive investors and traders are so-called algorithmic traders. The vast majority of algorithmic trading signals are based on momentum and other technical indicators. In these algorithms, considerations of value and risk are completely irrelevant. For example, these algorithms are not designed to take into account complex macroeconomic risks.
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