John Hussman provides a nice example of how to view the market as a split between different investor types, here technical traders vs. fundamental.
Hussman Funds: Imagine there being fundamental investors, who are interested primarily in value (buying on weakness and selling on strength), and technical investors, who are interested primarily in trends (selling on weakness and buying on strength). These people also trade on different horizons and base their trading on different extent of movement.
In this sort of equilibrium, trading volume is a measure of strong views and disagreement. As the market turns weaker, trend-following investors typically abandon stocks, while fundamental investors accumulate. The reverse is true on significant strength. So spikes in trading volume tend to occur primarily at extremes relative to the target prices of fundamental investors. Volume spikes also tend to be correlated with a series of positive or negative shocks that then abate. In contrast, dull volume is a measure of low sponsorship, strong agreement, and lack of external shocks.
Equally important is that net incipient buying from both technical and fundamental investors cannot exist, so large price movements are typically required to relieve the disequilibrium. If you’ve got an overvalued market which then loses technical support, the outcome can be extremely negative, because technical investors are prompted to sell, but fundamental investors have weak sponsorship at that point, so large price declines are required to induce the fundamental investors to absorb the supply.
Given that he describes the current market as overvalued, he clearly sees risk of a substantial pull back should market momentum fail. The question is how exactly he’s calculating valuation, since the downside for any near-term market pull back might not be too severe.
His valuation vs. forward returns chart for stocks is below. Actual 10-year forward annual stock returns are in dark blue, while the other coloured lines represent PE levels of 20, 14, 11, and 7. Though to be frank, we can’t decipher what earnings he is actually using. Feel free to enlighten us.