Sooner or later a crash is coming, and it may be terrific.
– Roger Babson, September 5, 1929
Roger Babson’s first rule of investing was “keep speculation and investments separate.” He is remembered not only for founding Babson College in Massachusetts, but also for his speech at the National Business Conference, warning of an impending crash just two days after the 1929 peak, at the very beginning of a decline that would wipe out 89% of the value of the Dow Jones Industrial Average.
As I’ve observed before, the back-story is that Babson’s presentation began as follows: “I’m about to repeat what I said at this time last year, and the year before…” The fact is that Babson had been “proven wrong” by an advance that had taken stocks relentlessly higher, doubling during those two preceding years. Over the next 10 weeks, all of those market gains would be erased. If Babson was “too early,” it certainly didn’t matter. From the low of the 1929 plunge, the stock market would then lose an additional 79% of its value by its eventual bottom in 1932 because of add-on policy errors that resulted in the Great Depression.
To slightly paraphrase Ben Hunt, how does something go down 90%? First it goes down 50%, then it goes down 80% more.
This lesson has been repeated, to varying degrees, at every market extreme across history. For example, the 1973-1974 decline wiped out the entire excess total return of the S&P 500 Index (market returns over and above T-bill returns) all the way back to October 1958. The 2000-2002 market decline wiped out the entire excess total return of the S&P 500 Index all the way back to May 1996. The 2007-2009 market decline wiped out the entire excess total return of the S&P 500 Index all the way back to June 1995. I expect that the completion of the current market cycle will wipe out the entire excess total return of the S&P 500 Index all the way back to about October 1997. That outcome wouldn’t even require the most reliable valuation measures we identify to breach their pre-bubble norms.
The chart below presents several valuation measures we find most strongly correlated with actual subsequent S&P 500 total returns in market cycles across history. They are presented as percentage deviations from their historical norms. At the January peak, these measures extended about 200% above (three times) historical norms that we associate with average, run-of-the-mill prospects for long-term market returns. No market cycle in history – not even those of recent decades, nor those associated with low interest rates – has ended without taking our most reliable measures of valuation to less than half of their late-January levels.
Don’t imagine that a market advance “disproves” concerns about overvaluation. In a steeply overvalued market, further advances typically magnify the losses that follow, ultimately wiping out years, and sometimes more than a decade, of what the market has gained relative to risk-free cash.
Daily news versus latent risks
I’ve been increasingly asked my opinion of the recent market volatility. The proper answer, I think, is that we’re observing the very early effects of risk-aversion in a hypervalued market. To some extent, the actual news events are irrelevant. I certainly wouldn’t gauge market risk by monitoring the day-to-day news on potential tariffs or even prospects for rate changes by the Fed.
Indeed, when our measures of market internals have been unfavorable (signaling risk-averse investor psychology), the S&P 500 has historically lost value, on average, even during periods of Fed easing, falling interest rates, or interest rates pinned near zero. The reason is that when investors are inclined toward risk-aversion, safe liquidity is a desirable asset rather than an inferior one, so creating more of the stuff doesn’t provoke speculation.
This distinction – that Fed easing can strongly amplify existing speculative pressures but is often wholly ineffective when investors are inclined to risk-aversion – is likely to smack believers in a “Fed put” like a ton of bricks over the completion of this cycle. It wouldn’t be a surprise if the financial memory of investors wasn’t so selective. Recall that the Fed eased aggressively and persistently throughout the 2000-2002 and 2007-2009 collapses.
In a speculative market, bad news is good news and good news is good news. In a risk-averse market, the opposite is true. When investors have to argue among themselves about which news event is causing them to worry, the news is probably just providing day-to-day occasions for investors to act on more general concerns, like extreme valuation.
Does anyone really think the market crashed in October 1987 because of a larger-than-expected trade deficit with Germany? That’s the only news event people could find that day, and investors would fearfully monitor every blip in trade reports months afterward. Attributing the market change of the day to the particular news of the day is an exercise in spurious correlation. Unless there’s an event that will materially alter the long-term stream of cash flows that will be delivered by companies to investors for decades to come, what you’re actually seeing is a daily dance of surface-level investor psychology that gradually reveals or obscures the latent fundamentals below. (...)
Investment and speculation
Both Benjamin Graham and Roger Babson were careful to distinguish investment from speculation. This remains a critical distinction today. Understanding it will make an enormous difference to investors in the coming years.
At its core, speculation is about psychology. It’s about waves of optimism and pessimism that drive fluctuations in price, regardless of valuation. Value investors tend to look down on speculation, particularly extended periods of it. Unfortunately, if a material portion of one’s life must be lived amid episodes of reckless speculation that repeatedly collapse into heaps of ash, one is forced to make a choice. One choice is to imagine that speculation is actually investment, which is what most investors inadvertently do. The other choice is to continue to distinguish speculation from investment, and develop ways to measure and navigate both.
The central tools of speculative analysis focus on the observable prices, trading volume, sentiment, and other objects that emerge as the expression of investor psychology. For our part, two sorts of measures are useful; one dealing with the uniformity or divergence of price behavior, and the other dealing with overextended extremes.
We gauge investor preferences toward speculation or risk-aversion by extracting a signal from what we call “market internals” – the behavior of thousands of securities; individual stocks, industries, sectors, and security-types, including debt securities of varying creditworthiness. While we do keep our methods proprietary on that front, we’re very open about the underlying concepts: 1) when investors are inclined to speculate, they tend to be indiscriminate about it, and 2) when two securities diverge, the dispersion provides information about factors that they do not share in common. As a simple example, consider junk bonds versus high-grade bonds. Uniform market action conveys information or investor perceptions about interest rate pressures. Divergence conveys information or investor perceptions about oncoming credit risk and default.
With regard to overextended extremes, prior episodes of speculation in market cycles across history usually ended, or encountered sharp air-pockets, at the point where valuations, price extremes, and investor sentiment simultaneously reflected overvalued, overbought, overbullish conditions. Unfortunately, we learned the very hard way in recent years that, faced with zero interest rate policies, these syndromes were virtually useless in signaling even a pause in the relentless yield-seeking speculation and “there is no alternative” mindset that the Federal Reserve deliberately encouraged. So we had to adapt, ultimately restricting our discipline from taking a negative outlook unless we also observed explicit deterioration in our measures of market internals.
At present, stock market investors are faced with offensively extreme valuations, particularly among the measures best-correlated with actual subsequent market returns across history. Investment merit is absent. Investors largely ignored extreme “overvalued, overbought, overbullish” syndromes through much of the recent half-cycle advance, yet even since 2009, the S&P 500 has lost value, on average, when these syndromes were joined by unfavorable market internals.
We observed a clear deterioration in our measures of market internals in the week of February 2nd. While we have to be open to changes in market internals that might signal a resumption of speculative investor psychology, we don’t see that here. So speculative merit is also absent (apart than the rather weak potential that emerges from short-term “oversold” conditions). When we examine market collapses across history, the common feature is that both investment merit and speculative merit are absent.
– Roger Babson, September 5, 1929
Roger Babson’s first rule of investing was “keep speculation and investments separate.” He is remembered not only for founding Babson College in Massachusetts, but also for his speech at the National Business Conference, warning of an impending crash just two days after the 1929 peak, at the very beginning of a decline that would wipe out 89% of the value of the Dow Jones Industrial Average.
As I’ve observed before, the back-story is that Babson’s presentation began as follows: “I’m about to repeat what I said at this time last year, and the year before…” The fact is that Babson had been “proven wrong” by an advance that had taken stocks relentlessly higher, doubling during those two preceding years. Over the next 10 weeks, all of those market gains would be erased. If Babson was “too early,” it certainly didn’t matter. From the low of the 1929 plunge, the stock market would then lose an additional 79% of its value by its eventual bottom in 1932 because of add-on policy errors that resulted in the Great Depression.
To slightly paraphrase Ben Hunt, how does something go down 90%? First it goes down 50%, then it goes down 80% more.
This lesson has been repeated, to varying degrees, at every market extreme across history. For example, the 1973-1974 decline wiped out the entire excess total return of the S&P 500 Index (market returns over and above T-bill returns) all the way back to October 1958. The 2000-2002 market decline wiped out the entire excess total return of the S&P 500 Index all the way back to May 1996. The 2007-2009 market decline wiped out the entire excess total return of the S&P 500 Index all the way back to June 1995. I expect that the completion of the current market cycle will wipe out the entire excess total return of the S&P 500 Index all the way back to about October 1997. That outcome wouldn’t even require the most reliable valuation measures we identify to breach their pre-bubble norms.
The chart below presents several valuation measures we find most strongly correlated with actual subsequent S&P 500 total returns in market cycles across history. They are presented as percentage deviations from their historical norms. At the January peak, these measures extended about 200% above (three times) historical norms that we associate with average, run-of-the-mill prospects for long-term market returns. No market cycle in history – not even those of recent decades, nor those associated with low interest rates – has ended without taking our most reliable measures of valuation to less than half of their late-January levels.
Don’t imagine that a market advance “disproves” concerns about overvaluation. In a steeply overvalued market, further advances typically magnify the losses that follow, ultimately wiping out years, and sometimes more than a decade, of what the market has gained relative to risk-free cash.
Daily news versus latent risks
I’ve been increasingly asked my opinion of the recent market volatility. The proper answer, I think, is that we’re observing the very early effects of risk-aversion in a hypervalued market. To some extent, the actual news events are irrelevant. I certainly wouldn’t gauge market risk by monitoring the day-to-day news on potential tariffs or even prospects for rate changes by the Fed.
Indeed, when our measures of market internals have been unfavorable (signaling risk-averse investor psychology), the S&P 500 has historically lost value, on average, even during periods of Fed easing, falling interest rates, or interest rates pinned near zero. The reason is that when investors are inclined toward risk-aversion, safe liquidity is a desirable asset rather than an inferior one, so creating more of the stuff doesn’t provoke speculation.
This distinction – that Fed easing can strongly amplify existing speculative pressures but is often wholly ineffective when investors are inclined to risk-aversion – is likely to smack believers in a “Fed put” like a ton of bricks over the completion of this cycle. It wouldn’t be a surprise if the financial memory of investors wasn’t so selective. Recall that the Fed eased aggressively and persistently throughout the 2000-2002 and 2007-2009 collapses.
In a speculative market, bad news is good news and good news is good news. In a risk-averse market, the opposite is true. When investors have to argue among themselves about which news event is causing them to worry, the news is probably just providing day-to-day occasions for investors to act on more general concerns, like extreme valuation.
Does anyone really think the market crashed in October 1987 because of a larger-than-expected trade deficit with Germany? That’s the only news event people could find that day, and investors would fearfully monitor every blip in trade reports months afterward. Attributing the market change of the day to the particular news of the day is an exercise in spurious correlation. Unless there’s an event that will materially alter the long-term stream of cash flows that will be delivered by companies to investors for decades to come, what you’re actually seeing is a daily dance of surface-level investor psychology that gradually reveals or obscures the latent fundamentals below. (...)
Investment and speculation
Both Benjamin Graham and Roger Babson were careful to distinguish investment from speculation. This remains a critical distinction today. Understanding it will make an enormous difference to investors in the coming years.
When we examine market collapses across history, the common feature is that both investment merit and speculative merit are absent.At its core, investment is about valuation. It’s about purchasing a stream of expected future cash flows at a price that’s low enough to result in desirable total returns, at an acceptable level of risk, as those cash flows are delivered over time. The central tools of investment analysis include an understanding of market history, cash flow projection, the extent to which various measures of financial performance can be used as “sufficient statistics” for that very long-term stream of cash flows (which is crucial whenever valuation ratios are used as a shorthand for discounted cash flow analysis), and a command of the basic arithmetic that connects the current price, the future cash flows, and the long-term rate of return.
At its core, speculation is about psychology. It’s about waves of optimism and pessimism that drive fluctuations in price, regardless of valuation. Value investors tend to look down on speculation, particularly extended periods of it. Unfortunately, if a material portion of one’s life must be lived amid episodes of reckless speculation that repeatedly collapse into heaps of ash, one is forced to make a choice. One choice is to imagine that speculation is actually investment, which is what most investors inadvertently do. The other choice is to continue to distinguish speculation from investment, and develop ways to measure and navigate both.
The central tools of speculative analysis focus on the observable prices, trading volume, sentiment, and other objects that emerge as the expression of investor psychology. For our part, two sorts of measures are useful; one dealing with the uniformity or divergence of price behavior, and the other dealing with overextended extremes.
We gauge investor preferences toward speculation or risk-aversion by extracting a signal from what we call “market internals” – the behavior of thousands of securities; individual stocks, industries, sectors, and security-types, including debt securities of varying creditworthiness. While we do keep our methods proprietary on that front, we’re very open about the underlying concepts: 1) when investors are inclined to speculate, they tend to be indiscriminate about it, and 2) when two securities diverge, the dispersion provides information about factors that they do not share in common. As a simple example, consider junk bonds versus high-grade bonds. Uniform market action conveys information or investor perceptions about interest rate pressures. Divergence conveys information or investor perceptions about oncoming credit risk and default.
With regard to overextended extremes, prior episodes of speculation in market cycles across history usually ended, or encountered sharp air-pockets, at the point where valuations, price extremes, and investor sentiment simultaneously reflected overvalued, overbought, overbullish conditions. Unfortunately, we learned the very hard way in recent years that, faced with zero interest rate policies, these syndromes were virtually useless in signaling even a pause in the relentless yield-seeking speculation and “there is no alternative” mindset that the Federal Reserve deliberately encouraged. So we had to adapt, ultimately restricting our discipline from taking a negative outlook unless we also observed explicit deterioration in our measures of market internals.
At present, stock market investors are faced with offensively extreme valuations, particularly among the measures best-correlated with actual subsequent market returns across history. Investment merit is absent. Investors largely ignored extreme “overvalued, overbought, overbullish” syndromes through much of the recent half-cycle advance, yet even since 2009, the S&P 500 has lost value, on average, when these syndromes were joined by unfavorable market internals.
We observed a clear deterioration in our measures of market internals in the week of February 2nd. While we have to be open to changes in market internals that might signal a resumption of speculative investor psychology, we don’t see that here. So speculative merit is also absent (apart than the rather weak potential that emerges from short-term “oversold” conditions). When we examine market collapses across history, the common feature is that both investment merit and speculative merit are absent.
by John P. Hussman Ph.D., Hussman Funds | Read more:
Image: Hussman Funds
