A month ago, I noted that prevailing valuation extremes implied negative total returns for the S&P 500 on 10-12 year horizon, and losses on the order of two-thirds of the market’s value over the completion of the current market cycle. With our measures of market internals constructive, on balance, we had maintained a rather neutral near-term outlook for months, despite the most extreme “overvalued, overbought, overbullish” syndromes in U.S. history. Still, I noted, “I believe that it’s essential to carry a significant safety net at present, and I’m also partial to tail-risk hedges that kick-in automatically as the market declines, rather than requiring the execution of sell orders. My impression is that the first leg down will be extremely steep, and that a subsequent bounce will encourage investors to believe the worst is over.”
On February 2nd, our measures of market internals clearly deteriorated, shifting market conditions to a combination of extreme valuations and unfavorable market internals, coming off of the most extremely overextended conditions we’ve ever observed in the historical data. At present, I view the market as a “broken parabola” – much the same as we observed for the Nikkei in 1990, the Nasdaq in 2000, or for those wishing a more recent example, Bitcoin since January.
Two features of the initial break from speculative bubbles are worth noting. First, the collapse of major bubbles is often preceded by the collapse of smaller bubbles representing “fringe” speculations. Those early wipeouts are canaries in the coalmine. For example, in July 2000, the Wall Street Journal ran an article titled (in the print version) “What were we THINKING?” – reflecting on the “arrogance, greed, and optimism” that had already been followed by the collapse of dot-com stocks. My favorite line: “Now we know better. Why didn’t they see it coming?” Unfortunately, that article was published at a point where the Nasdaq still had an 80% loss (not a typo) ahead of it.
Similarly, in July 2007, two Bear Stearns hedge funds heavily invested in sub-prime loans suddenly became nearly worthless. Yet that was nearly three months before the S&P 500 peaked in October, followed by a collapse that would take it down by more than 55%. (...)
As I’ve emphasized in prior market comments, valuations are the primary driver of investment returns over a 10-12 year horizon, and of prospective losses over the completion of any market cycle, but they are rather useless indications of near-term returns. What drives near-term outcomes is the psychological inclination of investors toward speculation or risk-aversion. We infer that preference from the uniformity or divergence of market internals across a broad range of securities, sectors, industries, and security-types, because when investors are inclined to speculate, they tend to be indiscriminate about it. This has been true even in the advancing half-cycle since 2009.
The only difference in recent years was that, unlike other cycles where extreme “overvalued, overbought, overbullish” features of market action reliably warned that speculation had gone too far, these syndromes proved useless in the face of zero interest rates. Evidently, once interest rates hit zero, so did the collective IQ of Wall Street. We adapted incrementally, by placing priority on the condition of market internals, over and above those overextended syndromes. Ultimately, we allowed no exceptions.
The proper valuation of long-term discounted cash flows requires the understanding that if interest rates are low because growth rates are also low, no valuation premium is “justified” by the low interest rates at all. It requires consideration of how the structural drivers of GDP growth (labor force growth and productivity) have changed over time.
Careful, value-conscious, historically-informed analysis can serve investors well over the complete market cycle, but that analysis must also include investor psychology (which we infer from market internals). In a speculative market, it’s not the understanding of valuation, or economics, or a century of market cycles that gets you into trouble. It’s the assumption that anyone cares.
The important point is this: Extreme valuations are born not of careful calculation, thoughtful estimation of long-term discounted cash flows, or evidence-based reasoning. They are born of investor psychology, self-reinforcing speculation, and verbal arguments that need not, and often do not, hold up under the weight of historical data. Once investor preferences shift from speculation toward risk-aversion, extreme valuations should not be ignored, and can suddenly matter to their full extent. It appears that the financial markets may have reached that point.
A second feature of the initial break from a speculative bubble, which I observed last month, is that the first leg down tends to be extremely steep, and a subsequent bounce encourages investors to believe that the worst is over. That feature is clearly evident when we examine prior financial bubbles across history. Dr. Jean-Paul Rodrigue describes an idealized bubble as a series of phases, including that sort of recovery from the initial break, which he describes as a “bull trap.”
I continue to expect the S&P 500 to lose about two-thirds of its value over the completion of the current market cycle. With market internals now unfavorable, following the most offensive “overvalued, overbought, overbullish” combination of market conditions on record, our market outlook has shifted to hard-negative. Rather than forecasting how long present conditions may persist, I believe it’s enough to align ourselves with prevailing market conditions, and shift our outlook as those conditions shift. That leaves us open to the possibility that market action will again recruit the kind of uniformity that would signal that investors have adopted a fresh willingness to speculate. We’ll respond to those changes as they arrive (ideally following a material retreat in valuations). For now, buckle up.
On February 2nd, our measures of market internals clearly deteriorated, shifting market conditions to a combination of extreme valuations and unfavorable market internals, coming off of the most extremely overextended conditions we’ve ever observed in the historical data. At present, I view the market as a “broken parabola” – much the same as we observed for the Nikkei in 1990, the Nasdaq in 2000, or for those wishing a more recent example, Bitcoin since January.
Two features of the initial break from speculative bubbles are worth noting. First, the collapse of major bubbles is often preceded by the collapse of smaller bubbles representing “fringe” speculations. Those early wipeouts are canaries in the coalmine. For example, in July 2000, the Wall Street Journal ran an article titled (in the print version) “What were we THINKING?” – reflecting on the “arrogance, greed, and optimism” that had already been followed by the collapse of dot-com stocks. My favorite line: “Now we know better. Why didn’t they see it coming?” Unfortunately, that article was published at a point where the Nasdaq still had an 80% loss (not a typo) ahead of it.
Similarly, in July 2007, two Bear Stearns hedge funds heavily invested in sub-prime loans suddenly became nearly worthless. Yet that was nearly three months before the S&P 500 peaked in October, followed by a collapse that would take it down by more than 55%. (...)
As I’ve emphasized in prior market comments, valuations are the primary driver of investment returns over a 10-12 year horizon, and of prospective losses over the completion of any market cycle, but they are rather useless indications of near-term returns. What drives near-term outcomes is the psychological inclination of investors toward speculation or risk-aversion. We infer that preference from the uniformity or divergence of market internals across a broad range of securities, sectors, industries, and security-types, because when investors are inclined to speculate, they tend to be indiscriminate about it. This has been true even in the advancing half-cycle since 2009.
The only difference in recent years was that, unlike other cycles where extreme “overvalued, overbought, overbullish” features of market action reliably warned that speculation had gone too far, these syndromes proved useless in the face of zero interest rates. Evidently, once interest rates hit zero, so did the collective IQ of Wall Street. We adapted incrementally, by placing priority on the condition of market internals, over and above those overextended syndromes. Ultimately, we allowed no exceptions.
The proper valuation of long-term discounted cash flows requires the understanding that if interest rates are low because growth rates are also low, no valuation premium is “justified” by the low interest rates at all. It requires consideration of how the structural drivers of GDP growth (labor force growth and productivity) have changed over time.
Careful, value-conscious, historically-informed analysis can serve investors well over the complete market cycle, but that analysis must also include investor psychology (which we infer from market internals). In a speculative market, it’s not the understanding of valuation, or economics, or a century of market cycles that gets you into trouble. It’s the assumption that anyone cares.
The important point is this: Extreme valuations are born not of careful calculation, thoughtful estimation of long-term discounted cash flows, or evidence-based reasoning. They are born of investor psychology, self-reinforcing speculation, and verbal arguments that need not, and often do not, hold up under the weight of historical data. Once investor preferences shift from speculation toward risk-aversion, extreme valuations should not be ignored, and can suddenly matter to their full extent. It appears that the financial markets may have reached that point.
A second feature of the initial break from a speculative bubble, which I observed last month, is that the first leg down tends to be extremely steep, and a subsequent bounce encourages investors to believe that the worst is over. That feature is clearly evident when we examine prior financial bubbles across history. Dr. Jean-Paul Rodrigue describes an idealized bubble as a series of phases, including that sort of recovery from the initial break, which he describes as a “bull trap.”
I continue to expect the S&P 500 to lose about two-thirds of its value over the completion of the current market cycle. With market internals now unfavorable, following the most offensive “overvalued, overbought, overbullish” combination of market conditions on record, our market outlook has shifted to hard-negative. Rather than forecasting how long present conditions may persist, I believe it’s enough to align ourselves with prevailing market conditions, and shift our outlook as those conditions shift. That leaves us open to the possibility that market action will again recruit the kind of uniformity that would signal that investors have adopted a fresh willingness to speculate. We’ll respond to those changes as they arrive (ideally following a material retreat in valuations). For now, buckle up.
by John P. Hussman, Ph.D. Hussman Funds | Read more:
Image: Dr. Jean-Paul Rodrigue
