At the height of the technology bubble, the median of the most reliable market valuation measures we follow (those most strongly correlated with actual subsequent S&P 500 total returns) briefly reached an apex 178% above historical norms that had been regularly approached or breached over the completion of every market cycle in history. That level of valuation implied a prospective market loss of (1/(1+1.78)-1 = ) -64% as the bubble collapsed. In real-time, I suggested, based on related measures, that prospective market losses would likely be tiered, with tech stocks losing about -83%, the S&P 500 losing more than half of its value. As it happened, the 2000-2002 collapse took the S&P 500 down by 50%, while the tech-heavy Nasdaq 100 Index lost an oddly precise -83%. Smaller capitalization stocks suffered less extensive losses due to better valuations, as they had materially lagged the large-cap indices during the late-stages of that bubble.
Attempting to “stimulate” the economy from the recession that followed, the Federal Reserve cut short-term interest rates to just 1%, provoking an episode of yield-seeking speculation, where yield-starved investors created demand for higher-yielding mortgage-backed securities, and a weakly-regulated Wall Street rushed to create new “product” to meet the demand (by lending to anyone with a pulse). At its peak, the resulting bubble took the median of the most reliable market valuation measures we follow to a level more than 95% above their historical norms, implying a prospective market loss on the order of -49% as that bubble collapsed.
While I've written about numerous valuation measures over time, the most reliable ones share a common feature: they focus on identifying "sufficient statistics" for the very, very long-term stream of cash flows that stocks can be expected to deliver into the hands of investors over time. On that front, revenues are typically more robust "sufficient statistics" than current or year-ahead earnings. See Exhaustion Gaps and the Fear of Missing Out for a table showing the relative reliability of a variety of measures. In April 2007, I estimated that an appropriate valuation for the S&P 500 stood about 850, roughly -40% lower than prevailing levels. By the October peak, the prospective market loss to normal valuation had increased to about -46%. As it happened, the subsequent collapse of the housing bubble took the S&P 500 about -55% lower. In late-October 2008, as the market plunge crossed below historically reliable valuation norms, I observed that the S&P 500 had become undervalued on our measures.
Again attempting to “stimulate” the economy from the recession that followed, the Federal Reserve cut short-term interest rates to zero in recent years, provoking yet another episode of yield-seeking speculation, where yield-starved investors created demand for virtually every class of securities, in the hope of achieving returns in excess of zero. Meanwhile, Wall Street, suffering from what J.K. Galbraith once called the “extreme brevity of the financial memory,” convinced itself yet again that the whole episode was built on something more solid than quotes on a screen and blotches of ink on paper. At last week’s highs, the median of the most reliable market valuation measures we follow reached an extreme that placed them 170% above their historical norms, implying a prospective market loss on the order of -63% in what I fully expect to be the collapse of the third speculative bubble since 2000. Notably, there is only a single week in history where the median valuation on our most reliable measures exceeded the level we just observed. That was the week of March 24, 2000, which set the peak of the tech bubble. Unlike the 2000-2002 retreat however, the damage to paper values over the completion of the current cycle is likely to spare few sectors, as the median valuation across individual stocks is at a record high, and far beyond the 2000 peak. (...)
By the completion of the current cycle, investors will likely relearn how erroneous and irrelevant it was to worry about “selling too early” in an extremely overvalued market. It’s worth remembering now that by the end of the 2000-2002 decline, the entire total return of the S&P 500, in excess of Treasury bills, had been wiped out all the way back to May 1996. By the end of the 2007-2009 collapse, the entire total return of the S&P 500, in excess of Treasury bills, had been wiped out all the way back to June 1995. Likewise, my expectation is that the completion of the current market cycle will wipe out the total returns of the S&P 500, in excess of Treasury bill returns, all the way back to roughly October 1997 (from the standpoint of of the recent bull market advance, that would also erase the entire total return of the S&P 500, in excess of Treasury bill returns, since late-2009). This outcome would not even require the most reliable valuation measures to breach historical norms that they have revisited in virtually every market cycle, even those associated with very low interest rates. See Durable Returns, Transient Returns for a reminder of how all of this works.
Having correctly anticipated and watched major collapses unfold in prior market cycles, my sense is that many investors are likely thinking “I can always get out if the news gets bad and a steep loss starts to unfold.” More likely, what will actually happen is that the first market loss off the top will be a nearly vertical drop on the order of 12-14% and will be associated with virtually no meaningful news at all, and most investors will consider the decline far too steep to make selling worthwhile. A subsequent advance from that low, whether it recovers a third, or a half, or nearly all of the loss, will reinforce that mentality. Except for outright crashes like 1987, steep market losses are regularly punctuated by fast, furious advances that restore hope, and then give way to a fresh cascade of losses. If possible, get some charts and go through a few past market collapses day-by-day (blocking out the right side so it’s not clear what happened next), and you’ll get a feel for this constant flux between fear and relief, all the way down.
Attempting to “stimulate” the economy from the recession that followed, the Federal Reserve cut short-term interest rates to just 1%, provoking an episode of yield-seeking speculation, where yield-starved investors created demand for higher-yielding mortgage-backed securities, and a weakly-regulated Wall Street rushed to create new “product” to meet the demand (by lending to anyone with a pulse). At its peak, the resulting bubble took the median of the most reliable market valuation measures we follow to a level more than 95% above their historical norms, implying a prospective market loss on the order of -49% as that bubble collapsed.
While I've written about numerous valuation measures over time, the most reliable ones share a common feature: they focus on identifying "sufficient statistics" for the very, very long-term stream of cash flows that stocks can be expected to deliver into the hands of investors over time. On that front, revenues are typically more robust "sufficient statistics" than current or year-ahead earnings. See Exhaustion Gaps and the Fear of Missing Out for a table showing the relative reliability of a variety of measures. In April 2007, I estimated that an appropriate valuation for the S&P 500 stood about 850, roughly -40% lower than prevailing levels. By the October peak, the prospective market loss to normal valuation had increased to about -46%. As it happened, the subsequent collapse of the housing bubble took the S&P 500 about -55% lower. In late-October 2008, as the market plunge crossed below historically reliable valuation norms, I observed that the S&P 500 had become undervalued on our measures.
Again attempting to “stimulate” the economy from the recession that followed, the Federal Reserve cut short-term interest rates to zero in recent years, provoking yet another episode of yield-seeking speculation, where yield-starved investors created demand for virtually every class of securities, in the hope of achieving returns in excess of zero. Meanwhile, Wall Street, suffering from what J.K. Galbraith once called the “extreme brevity of the financial memory,” convinced itself yet again that the whole episode was built on something more solid than quotes on a screen and blotches of ink on paper. At last week’s highs, the median of the most reliable market valuation measures we follow reached an extreme that placed them 170% above their historical norms, implying a prospective market loss on the order of -63% in what I fully expect to be the collapse of the third speculative bubble since 2000. Notably, there is only a single week in history where the median valuation on our most reliable measures exceeded the level we just observed. That was the week of March 24, 2000, which set the peak of the tech bubble. Unlike the 2000-2002 retreat however, the damage to paper values over the completion of the current cycle is likely to spare few sectors, as the median valuation across individual stocks is at a record high, and far beyond the 2000 peak. (...)
By the completion of the current cycle, investors will likely relearn how erroneous and irrelevant it was to worry about “selling too early” in an extremely overvalued market. It’s worth remembering now that by the end of the 2000-2002 decline, the entire total return of the S&P 500, in excess of Treasury bills, had been wiped out all the way back to May 1996. By the end of the 2007-2009 collapse, the entire total return of the S&P 500, in excess of Treasury bills, had been wiped out all the way back to June 1995. Likewise, my expectation is that the completion of the current market cycle will wipe out the total returns of the S&P 500, in excess of Treasury bill returns, all the way back to roughly October 1997 (from the standpoint of of the recent bull market advance, that would also erase the entire total return of the S&P 500, in excess of Treasury bill returns, since late-2009). This outcome would not even require the most reliable valuation measures to breach historical norms that they have revisited in virtually every market cycle, even those associated with very low interest rates. See Durable Returns, Transient Returns for a reminder of how all of this works.
Having correctly anticipated and watched major collapses unfold in prior market cycles, my sense is that many investors are likely thinking “I can always get out if the news gets bad and a steep loss starts to unfold.” More likely, what will actually happen is that the first market loss off the top will be a nearly vertical drop on the order of 12-14% and will be associated with virtually no meaningful news at all, and most investors will consider the decline far too steep to make selling worthwhile. A subsequent advance from that low, whether it recovers a third, or a half, or nearly all of the loss, will reinforce that mentality. Except for outright crashes like 1987, steep market losses are regularly punctuated by fast, furious advances that restore hope, and then give way to a fresh cascade of losses. If possible, get some charts and go through a few past market collapses day-by-day (blocking out the right side so it’s not clear what happened next), and you’ll get a feel for this constant flux between fear and relief, all the way down.
by John P. Hussman Ph.D., Hussman Funds | Read more:
