THE END OF HISTORY ILLUSION
In recent years, and especially throughout 2024, persistent market flows have steadily fuelled the accumulation of imbalances and risks within financial markets. The current investment landscape is defined by unprecedented extremes in concentration, optimism, positioning, and valuations. This ultra consensual "pricing for perfection" leaves markets fragile and vulnerable to sharp repricings should this central scenario fail to materialize. At the same time, the parametric environment —characterized by subdued volatilities, low correlations, and historically low risk premia— projects a deceptive anticipation of perpetual stability.
The interplay between these two contrasting dynamics creates a precarious balance—an explosive cocktail of mounting risks on one hand and dangerously complacent market pricing on the other. This situation reflects the “End of History Illusion” or "status quo bias", a cognitive bias that results in the belief that the current state of affairs is permanent. It fosters resistance to recognizing or preparing for potential upheavals, even in the face of clear warning signs.
SECTION 1: THE INVESTING LANDSCAPE
The current macroeconomic environment presents a unique convergence of factors: record-high concentration, record-high optimism, record-high positioning, and record-high valuations. Historically, periods marked by such exuberance and heightened confidence have coincided with significantly more attractive valuations. What stands out today, however, is the coexistence of bullish sentiment alongside elevated price-to-earnings ratios.
1A. CONCENTRATION: UNPRECEDENTED AND MULTI-DIMENSIONAL
Capital flows have never demonstrated such intense and multi-layered concentration. Firstly, there is a regional concentration of capital favoring the United States over the rest of the world (Figures 1 and 2). The U.S. is by far the largest recipient of foreign capital flows, making its stock market the largest globally, with no close competitor. Within the U.S., there is further concentration of capital in equities as compared to other asset classes (Figure 3). Additionally, within the equity markets, flows are heavily concentrated in technology stocks (Figure 4). Finally, there is a factor concentration, with “momentum,” “growth,” and “size” factors dominating others. As a result, markets have become increasingly fragile due to the accumulation of capital in a limited number of names (Figure 5).
This current setup, while not entirely, is largely the result of the rise of passive investing and an extreme adherence to benchmarks. Mutual funds and ETFs are now predominantly controlled by passive managers (Figure 6). For example, the primary reason the top five holders of Apple own shares in the company is their disciplined adherence to a benchmark, rather than a fundamental assessment of the iPhone maker. It is only when examining the sixth-largest holder (Berkshire Hathaway) that one finds a true fundamental investor.
This self-reinforcing narrative, combined with the fear of underperforming the S&P 500—the world’s leading benchmark—has directed global capital flows into this dominant index. Ironically, some of these flows, originally intended to diversify away from local stock markets, have ultimately resulted in an even more crowded position.
1B. SENTIMENT: FROM OPTIMISM TO EUPHORIA
At the end of November 2024, the Conference Board Consumer Confidence Survey revealed that 56.4% of respondents anticipated higher stock prices, marking the highest level of optimism since 1987 (Figure 7). Additionally, the combined percentage of respondents expecting higher stock prices and those anticipating lower interest rates reached a record-high of 91% (Figure 8).
While similar levels of euphoria have been observed in the past, these periods of intense optimism typically occurred following significant market corrections, during which valuation multiples were substantially lower.
1C. POSITIONING: RECORD OPTIMISM GIVES RISE TO RECORD EQUITY INFLOWS
As the saying goes, investors are “putting their money where their mouth is.” The extraordinary bullish sentiment described earlier is reflected in a 20-year high for inflows into U.S. equity ETFs and mutual funds (Figure 9).
Signs of exuberance and speculative fervor are also evident in derivatives markets. For the first time, volumes of 0DTE (same-day expiry) options have surpassed those of longer-dated options. This trend aligns with the broader appetite for leveraged exposure to tech stocks, with 0DTE options on Nasdaq products accounting for 60% of total volumes in 2024. The S&P 500 is not far behind, with 0DTE options representing 52% of total volumes in Q4 2024 (Figure 10).
1D. VALUATIONS: PRICING FOR PERFECTION
There are some well-documented, yet nonetheless staggering, facts: in December 2024, when the S&P 500 reached its all-time high, it marked the culmination of a 26-month bull run that delivered a 53% gain. During this period, the S&P 500 grew three times faster than its 50-year historical average. Such a rapid and sustained surge is exceedingly rare, having occurred only six times in the past 50 years: October 2022–December 2024, March 2020–May 2022, March 2009–April 2011, March 1997–May 1999, December 1994–February 1997, and December 1984–February 1987.
Despite the apparent excitement surrounding U.S. equities, valuations remain anything but cheap. Equity multiples have entered what can be described as an overheating regime. Research by Goldman Sachs, revealed that the U.S. valuations reached a 20-year peak in 2024 (Figure 11). While many market commentators attribute these lofty valuations to the so-called "Magnificent Seven," Goldman’s findings remain valid even when excluding the largest tech companies from the index.
Once again, U.S. exceptionalism stands out, as no other region in the study displayed similarly excessive valuation levels. This stark divergence underscores the unique dynamics driving the U.S. market, where optimism and concentrated capital flows have propelled valuations to unprecedented heights.
In addition to extremely high P/E ratios, the relative valuation of equities versus bonds is sitting at a level not reached in at least 25 years. Research from Tallbacken Capital Advisors demonstrates that the S&P 500 equity risk premium has compressed significantly, turning negative by the end of 2024 (Figure 12).
In summary, the S&P 500 appears overvalued both on an absolute basis (P/E ratios) and a relative basis (Equity Risk Premium).
1E. UNCERTAINTIES: INFLATION, RATES, AND CENTRAL BANK ROOM (OR LACK THEREOF) TO MANOEUVRE
For the first time in years, there is significant uncertainty about the Federal Reserve’s next move—will it raise interest rates or cut them? The COVID-19 crisis has amplified an already accelerating trend of rising private and public debt. Governments are finding it increasingly difficult to manage expanding budget deficits and mounting debt burdens.
Central banks, traditionally tasked with targeting inflation, now face the challenging responsibility of averting both deflationary and inflationary spirals. With sovereign debt levels at record highs, their mission becomes even more complex, particularly if inflation begins to rise. Striking a balance between maintaining price stability and ensuring financial stability in this precarious environment will be a formidable test for policymakers. Equity markets have demonstrated resilience to rising interest rates for some time. However, a renewed focus on debt sustainability could push yields higher, ultimately posing a threat to equity valuations.
Central banks, must continue reducing their balance sheets while minimizing disruptions to financial markets. In doing so, they may face criticism from governments eager to maintain accommodative monetary policies to stimulate economic growth. While central bank independence has been challenged before, the incoming U.S. administration may adopt a more vocal stance in expressing dissatisfaction.
Moreover, the effectiveness of monetary policy and inflation targeting is increasingly under scrutiny. Despite efforts to keep inflation near target and repeatedly rescue financial systems, these measures have failed to prevent the buildup of the imbalances described earlier. This raises questions about the long-term efficacy of current approaches and the ability of central banks to address systemic vulnerabilities.
Policymakers themselves, recognize the growing challenges ahead. In a speech at the LSE, Bank of France Governor François Villeroy de Galhau highlighted the transition from the "Great Moderation" era (mid-1980s to mid-2000s) to an anticipated period of "Great Volatility" (link here). Bank of Japan Deputy Governor, Ryozo Himino, said that the world could be entering a “Great Wave” phase in a reference to Hokusai’s work. The world famous prints “depicts small human beings facing the great force of nature, our ancestors enduring rough seas together on a small boat being toyed with by the waves,” Himino told a group of local leaders in Kanagawa (link here).
Finally, enhanced transparency and forward guidance became key features of central banks' communication during more straightforward times. While this effort is laudable in theory, it increases the number of constraints they must consider in more uncertain and volatile periods by heightening scrutiny and limiting their flexibility and ability to respond tactically.
1F. A SETUP UNIQUE IN HISTORY
As discussed in Section 1B, similar levels of euphoria have been observed in the past. What is unprecedented, however, is reaching such extraordinary levels of optimism amid such high valuations.
Sentiment, positioning, valuations, concentration, and uncertainty have compounded to create a precarious and potentially toxic setup that could prove incredibly painful in the event of reversal. Few scenarios are as damaging as the forced closure of overpriced, consensus-driven, and concentrated positions. These types of washouts often trigger liquidity gaps and amplify market volatility, creating a self-reinforcing cycle of disruption.
This alarming backdrop coincides with the dominance of beta in its various forms. The strong performance of beta-rich strategies—whether explicit or implicit—alongside the significant underperformance of beta-poor strategies, both reflects and reinforces the current patterns of asset and risk allocation and their associated imbalances.
This mechanism follows the classic spiral of ever-declining risk premia, which inevitably culminates in a dramatic blow-up. As detailed in our July 2024 paper (link here), this spiral is characterized by slow compression and rapid decompression—an unstable equilibrium at its core.
Whether driven by greed or fear of missing out, performance momentum rooted in back tests with little regard for future risk-reward, or the autopilot effects of passive benchmarking, the result is the same: the longer the exposure to beta, the better the recent performance, and the greater the accumulation of assets under management. Each time beta eclipses alpha, this narrative grows even more entrenched.
SECTION 2: THE PARAMETRIC ENVIRONMENT
The current market environment appears to largely disregard the accumulation of risks outlined above. Both implied and realized equity volatility levels remain near historical lows, as do correlations between assets, including equity indices from different regions or stocks within the same index.
2A. VOLATILITIES
Throughout 2024, realized volatility was notably subdued, ranging from low to ultra-low levels. For example, the SX5E exhibited lower realized volatility in 2024 compared to 2023 (Figure 16).
Similarly, in the U.S., long-term realized volatility painted a comparable picture. The 1-year realized volatility of the S&P 500 ended 2024 at just under 12.5%, placing it on the low end of the past 35 years (Figure 17). Remarkably, the S&P 500 delivered such strong performance with such low volatility that it achieved a Sharpe ratio of 2 for two consecutive years (2023 and 2024)—a feat last accomplished in 1975.
Interestingly, the International Monetary Fund (IMF), in its Financial Stability Report, highlights the stark disconnect between financial market volatility and the ongoing economic and geopolitical uncertainties. Figure 18 demonstrates that both metrics are deeply negative, with the gap between financial volatility and geopolitical risk reaching a 10-year extreme. While the objective of this paper is not to analyze geopolitical risks, we believe it is important to acknowledge their presence. Our focus remains on quantifiable parameters, where, as derivatives specialists, we can provide unique insights. However, it is worth drawing attention to the qualitative work of the IMF in this area as it underscores the broader context in which these dynamics are unfolding.
Within equity indices, expectations for future correlations are also exceptionally low, reaching levels that are clearly unsustainable (Figure 20). Current implied correlation levels offer a poor risk-reward profile for short correlation positions, yet these trades remain highly crowded. The combination of elevated anticipated dispersion and crowded positioning in these trades increases the potential for severe pain in the event of a correlation reversal.
Even correlations among stocks within the same sector are currently low. A striking example is the $22.5 trillion "chip complex," comprising the 27 most significant companies in the global semiconductor industry. Analyzing the realized correlation among the top 10 firms in this complex by market capitalization reveals surprisingly low levels of realized correlation (Figure 21). While we remain loyal to our investment process, which focuses on parametric dislocations rather than fundamental analysis, we aimed to explore the complex relationships linking these companies to gain a deeper understanding of their underlying interdependencies.
Figure 22 categorizes members of the chip complex based on their roles within the ecosystem, represented by distinct colors. Arrows indicate provider-client relationships, while the leaders in each group and their aggregated market capitalizations are displayed within the bubbles. Beyond the ecosystem’s staggering size—boasting a market cap equivalent to 45% of the S&P 500—what stands out is the deep interdependence among these companies.
Despite being fundamentally interconnected, operating within the same industry, trading with one another, and benefiting from a shared bullish business environment, their equity prices remain largely uncorrelated. This disconnect reflects a market heavily influenced by short-dated signals such as technicals and momentum, rather than by long-term fundamentals.
2C. LIQUIDITY
Liquidity, traditionally measured by volumes or bid-ask spreads, can be a deceptive indicator. Academic research has consistently highlighted the vanishing nature of liquidity, which tends to evaporate rapidly during periods of market stress. A November 2024 study by the Bank of International Settlements, titled (Through stormy seas: how fragile is liquidity across asset classes and time?), provides further evidence of this phenomenon. The study, which examines multiple asset classes and regions, observes “more frequent episodes of substantial illiquidity” in both stocks and government bonds during times of heightened volatility.
While the fragility of liquidity is not a new phenomenon, the situation has worsened. By definition, liquidity vanishes when bids and/or offers disappear. The significant concentration of capital in a small number of stocks amplifies this risk, potentially making the next liquidity gap far more severe.
2D. OTHER RISK PREMIA
Year-end provides a timely opportunity to revisit some of the key risk premia we monitor. Overall, we observe no dramatic shifts, as most risk premia are evolving gradually along the cycle. Those firmly positioned in the complacency quadrant, such as Equity Correlation, Equity Dispersion (as outlined in Section 2B), and Credit Spreads, have remained within this quadrant. Meanwhile, the few risk premia that moved out of the complacency quadrant into the first-losses quadrant over the summer are slowly returning to the bottom-right quadrant.
The one outlier is FX convexity, which continues to rise within the quadrants. This movement can largely be attributed to the fact that, in relative terms, this represents a minor cycle for EUR/USD convexity, which has been in a state of compression for the past two decades.
SECTION 3: MANAGING RISK IN TODAY'S MARKET CONTEXT
3A. THE IMPORTANCE OF PORTFOLIO CONSTRUCTION
Preparing for the unknown requires building a portfolio with complementary and diversified sources of returns. This means ensuring that different parts of the portfolio do not move in the same direction simultaneously. In today’s market, long beta dominates performance, leaving uncorrelated strategies struggling, losing assets, or disappearing, making them increasingly scarce for allocators. However, in a different market regime, this reliance on beta could become a significant liability. Diversification remains the only free lunch in finance.
In 2024, bonds and equities again exhibited positive correlation. Figure 24 shows the S&P 500 returned 25.02%, while the Bloomberg Global Aggregate Index gained 3.40%, with 2024 (blue dot) closely resembling 2023 (green dot). Though bonds and equities are traditionally viewed as risk-mitigating, Figure 24 illustrates their predominantly positive correlation over the past 35 years. Genuine diversifying strategies are rare but essential, and their role in portfolios must grow to improve resilience across market environments.
3B. USING ASYMMETRY TO MANAGE TIMING
To enhance long-term portfolio performance, a true diversifier must exhibit an asymmetric return profile i.e. modestly underperforming in strong markets with low volatility while significantly outperforming during heightened volatility and downturns. This requires structuring asymmetry at the trade level and robust portfolio construction to achieve the desired effect.
Asymmetry provides key advantages for allocators: it fosters patience, reduces reliance on market timing, and supports longer-term investment horizons. In a world without perfect foresight, holding diversifying and contrarian positions that incur small losses in stable markets is critical for managing risk and preparing for adverse scenarios.
TO CONCLUDE, compounding is one of the most powerful forces in finance; it is true for returns and true for risks. High equity valuation, record capital concentration, the dominance of passive investment, record positioning, historically bullish sentiment, low volatility, low correlation, and fragile liquidity, all are snowballing into a massive hazard.
The status quo bias, or end of history illusion, is fully at play here. It’s a cognitive bias which leads people to assume that the current state of the world will remain unchanged. It involves resistance to acknowledging or preparing for potential change. The human brain is designed to extrapolate the near future from the most recent past. While this can solve simple problems in life, this simple linear extrapolation is very poor at predicting the evolution of complex and random systems. Using yesterday’s information can yield good results in predicting today’s environment, but this strategy fails to anticipate the impact of compounding these daily small imbalances. After a while this compounding results in a massively different trajectory from the linear one.
Humans are very vulnerable to normative thinking. Again, this behavioral bias is a heuristic that was very useful in a different, simpler, context, when leaving the group could mean life or death. But today’s complex systems such as financial or political equilibrium evolve in a nonlinear way and are marked by substantial collapse and abrupt changes. Preparing for such events often means going against the collective dominant view of the world. It requires patience, determination, and more importantly courage.
It is fatuous to try predicting when the next episode of volatility will happen or what the trigger is going to be. However, as imbalances build up, the likelihood of it happening soon increases. At Adapt IM, we do not claim to know what the world will look like in a year or ten years from now, but we’re very confident to say that it will look substantially different from today’s world
On the parametric side, risk premia seem complacent considering the risks described above. Equity Indices Volatilities, Index-Index Correlations, Sectorial Correlations are all too low. In other asset classes, EURUSD Convexity and Credit spreads also appear compressed. The beauty of this dichotomy between the macro and parametric environment is that trades designed to benefit from a large change in the environment currently present attractive entry levels.
Taking the current macro and parametric environment into account, the crucial importance of real diversification in portfolio construction needs to be emphasized once more. More precisely, true diversifiers with embedded asymmetry are necessary to prepare for upcoming changes.
January 2025