Formula for Market Extremes

Guest Post by John Hussman

Market extremes generally share a common formula. One part reality is blended with one part misguided perception (typically extrapolating recent trends as if they are driven by some reliable and permanent mechanism), and often one part pure delusion (typically in the form of a colorful hallucination with elves, gnomes and dancing mushrooms all singing in harmony that reliable valuation measures no longer matter).

The technology bubble was grounded in legitimate realities including the emergence of the internet and a Great Moderation of stable GDP growth and contained inflation. But it also created a misperception that it was possible for an industry to achieve profits while having zero barriers to entry at the same time (the end of that misperception is why the dot-com bubble collapsed), a misperception that technology earnings would grow exponentially and were not cyclical (as we correctly argued in 2000 they would shortly prove to be), and the outright delusion that historically reliable valuation measures were no longer informative. Meanwhile, the same valuation measures we use today were projecting – in real time – negative 10-year nominal total returns for the S&P 500 over the coming decade, even under optimistic assumptions (see our August 2000 research letter).

The housing bubble was grounded in legitimate realities including a boom in residential housing construction and a legitimate economic recovery that followed the 2000-2002 bear market (which we responded to by shifting to a constructive stance in April 2003 despite valuations still being elevated on a historical basis). But the housing bubble also created a misperception that mortgage-backed securities were safe because housing prices had, at least to that point, never experienced a major collapse. The delusion was that housing was a sound investment at any price. The same delusion spread to the equity markets, helped by Fed-induced yield-seeking speculation by investors who were starved for safe return. Meanwhile, the same equity valuation measures we use today helped us to correctly warn investors of oncoming financial risks at the 2007 peak (see A Who’s Who of Awful Times to Invest).

The 2008 credit crisis, which we anticipated, was more challenging for us because the extent of employment losses and gravity of asset price collapse was greater than we had observed in the post-war data that underpinned our methods of assessing the market return/risk profile. Our valuation methods didn’t miss a beat, and correctly identified a shift to undervaluation after the late-2008 market plunge (see Why Warren Buffett is Right and Why Nobody Cares). But examining similar periods outside of post-war data, we found that measures of market action that were quite reliable in post-war data were heavily whipsawed in the Depression, and even the valuations we observed at the 2009 market lows were followed, in the Depression, by an additional loss of two-thirds of the market’s value. My resulting insistence on ensuring our methods were robust to that “two data sets” problem was necessary, but the timing could hardly have been worse, with an initial miss in the interim of that stress-testing, and an awkward transition to our present methods of classifying return/risk profiles.

The present market environment is grounded in the legitimate reality that the labor market has recovered its losses, but not to the extent that creates resource constraints or clear interest rate pressures. Though broad measures of economic activity have actually eased to year-over-year levels slightly below those that have historically distinguished expansions from recessions, the economy seems to be treading water, and don’t observe a particularly negative tone. Still, the recent period has created a misperception that monetary easing itself will support financial markets regardless of their valuation. The error here is that we know from history that it does not. Indeed, the 2000-2002 and 2007-2009 collapses both progressed in an environment of aggressive and sustained monetary easing. What’s actually true about monetary policy is that zero-interest rate policy has created a perception that investors have no alternative but to “reach for yield” in riskier assets. It’s entirely that reach for yield that investors must rely on continuing indefinitely, because there’s no mechanistic cause-effect relationship between the Fed balance sheet and stock prices, bank lending, or economic activity.

As usual, the delusion is that this Fed-induced reach for yield is enough to make equities a sound investment at any price. Ironically, the Fed itself is in the process of reversing course on this policy. Meanwhile, based on the same valuation methods that correctly projected negative 10-year returns at the 2000 peak, correctly gave us room to shift to a constructive position in early 2003, correctly helped us warn of severe market losses at the 2007 peak, and correctly identified the shift to market undervaluation in late-2008 (which those who don’t understand our stress-testing narrative may not recognize), we currently estimate prospective S&P 500 nominal total returns of just 2% annually over the coming decade, and negative returns on every horizon shorter than about 7 years.

In short, investors who are reaching for yield in stocks as an alternative to risk-free assets are most likely reaching for a negative total return in stocks between now and about 2021.

Read the rest of John Hussman’s Weekly Letter

1 thought on “Formula for Market Extremes”

  1. How Did This Happen?
    Author : Bill Holter
    Published: June 16th, 2014

    The Financial Times did a story over the weekend entitled “Central banks shift into equities.” Zero Hedge put this up Monday morning in response. The Official Monetary and Institutional Forum now say that central banks have invested $29.1 trillion into the global equity markets. Before going in to this, now we have a better understanding of how or “why” stock markets are “up.” We wondered how the markets were going up because everyone, EVERYONE so far this year has been reported to be a seller. We wondered where the money was coming from to propel prices higher is everyone was selling; now we know.

    I will give you a little perspective on this $29 trillion dollar figure because big numbers are thrown around like penny candy these days and we have become numbed (dumbed) down by such huge numbers. My point is this, there is no longer any shock value to any number no matter how large it is.

    OK, in perspective, the value of all stock markets on the planet added together is about $62 trillion. Now it is revealed that $29 trillion or so has come from the world’s central banks. How did this happen? Do central banks have an extra $29 trillion to throw around? The answer of course is no they do not …unless they just print it up and presto …there it is ready and able for whatever folly they choose. For a little more perspective, the Federal Reserve supposedly has a total balance sheet of some $4.5 trillion or about 15% of this $29 trillion (I dropped the “.1″ because it’s only $100 billion). But, this $4.5 trillion is all accounted for as being invested in treasuries, agencies …and some “junkier stuff.” Please don’t tell me that the world’s central banks are doing something that the Fed is not… or worse, the Fed is doing something that they are not admitting or accounting for!

    Do you understand what this really means? The Fed (central banks) own nearly 50% of all stocks. This means that yes, stocks are really manipulated and the tin foil hat crew was right again. It means that central banks can keep on creating fake money and putting that money into stocks to create fake(r) values…or …they can tank all of the stock markets worldwide at will with the press of a single button that has the word “sell” on it.

    Going even further down the rabbit hole, this means that central banks own nearly half of the equity in all publicly held businesses. It means that by simply printing money, they have “privatized” the world! Of course, there is no telling as to when exactly this scheme started but let’s assume that sometime late in 2008 or early ’09 would be a good guess. The markets needed support and it was a good entry level. Maybe this was something that “just happened” and then morphed into its current size? Maybe it wasn’t on purpose? I doubt this is the case as everything is orchestrated today, as the CIA is well known for saying, “There are no coincidences.” Who will the central banks sell to if they want out? Ahh, but why would they want out when they hold almost a majority position of the entire world.

    So, we have wondered how the stock markets have done, what they done and we wondered how in the U.S. the markets have done well while the Fed has tapered their QE by $1/2 trillion annualized. Now we know $500 billion is a pissant number that has been camouflaged by other, massive buying. Gold investors have also “wondered” how gold could go down in price while physical demand has far outstripped the actual supply. “We” have told you how for a long time now, all the while being called tin foil hat wearing conspiracy freaks. We told you that at least 100 ounces of “paper gold” were being created to divert capital away from the real thing. We told you that these paper ounces were being used to “dilute” the real thing and hide what was actually happening. Do you believe us now?

    Now that it turns out that an extra $29 trillion has been printed and “put to work” you must ask yourself several questions. First, if it was so easy to create all of this money (in the dark) and it is so plentiful, what is the money itself worth? What is it REALLY worth? Also, if the markets are where they are because of “unnatural” buying, where would they be trading on their own? How much lower? If gold is priced where it is today because there are 99 fakes out there for every real ounce then what is a real ounce worth if it is actually 99 times rarer? An even better question is this, if central banks were the sellers of real tangible gold for so many years and the conspiracy nuts are correct (as usual it seems lately) and the coffers are low, then what is an ounce worth?

    Let me ask this question in a slightly different manner. If the West’s central banks have very little gold yet retain the ability to print money and suddenly decide that they would like to stack some of the “lost” gold, what would that do to the price? Or even differently, if money supply approaches infinity and gold reserves approach zero…then what price? Is the answer not infinity?

    I hope that this revelation sinks in mentally for you. If not, please reread this because this is what it’s all about. You have been beaten over the head for at least 2 years to either sell your gold (and silver) or at least don’t buy it. It has been a psychological operation aimed directly at your finances through your emotions. Hopefully it hasn’t worked. If it has worked, then it is your jobs to “un” work it. Stand strong, buy more or buy for the first time, we now know that we are (and were) 100% correct, nothing should get between you and your insurance policy!


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