John Hussman with more facts for you to ignore. The market is going to crash. It might be a Greek default, a Chinese bubble bursting, or a Wall Street hedge fund blowing up. It’s always something. If it’s not one thing, it’s another.
Much of the investment world seems to view present conditions as a “Goldilocks market” where economic growth is positive enough to avoid recession, but not fast enough to provoke the Federal Reserve to hike interest rates. Even if these views on economic growth and Federal Reserve policy are correct, it hardly follows that stock prices will advance. S&P 500 returns are only weakly correlated with year-over-year GDP growth and have near-zero correlation with year-over-year changes in earnings. Likewise, the stance of the Federal Reserve has much less power to distinguish investment outcomes than investors seem to believe, which they might realize even by remembering that the Fed was easing aggressively and persistently throughout the 2000-2002 and 2007-2009 market collapses.
In contrast, we find profound differences in market outcomes across history depending on the combined status of valuations, market internals, and broader measures of market action (which include, for example, overvalued, overbought, overbullish syndromes). Some of these combinations, from most to least favorable, are:
1) Favorable valuations that are newly joined by a shift to favorable market internals;
2) Unfavorable valuations, coupled with favorable market internals, and without overvalued, overbought, overbullish features – which is an environment where speculation is reasonable;
3) Favorable valuations but without favorable market internals – where we observe positive average market returns but higher variability than in any other classification;
4) Unfavorable valuations, favorable market internals, but the emergence of overvalued, overbought overbullish features – which typically results in what I call “unpleasant skew”: a tendency toward persistent, marginal new highs, punctuated by “air pockets” that can wipe out weeks or months of progress in a handful of sessions, though the risk of a deeper crash becomes significant only after market internals also deteriorate;
5) Unfavorable valuations and unfavorable market internals, coming off of a recent period of overvalued, overbought, overbullish conditions – which represents the most severe return/risk profile we identify, and captures the bulk of historical market crashes.
The problem with obscene valuations and unfavorable market internals, coming off of an extended period of overvalued, overbought, overbullish conditions is that this environment couples low risk premiums with upward pressure on those risk premiums, which is the formula for a market collapse. If one reviews prior historical instances where market conditions were similar, the main question was generally not whether significant losses would unfold.
The main question also wasn’t when significant losses would unfold: once market internals had deteriorated, the most reliable answer was “maybe immediately, probably shortly, and maybe after some churning.” Whether the plunge began rather immediately – as in 1929 and 1987 – or after several months of sideways distribution – as in 2000 and 2007 and perhaps today – it was nearly impossible to narrow the time frame, at least on any measure we’ve tested across history. Moreover, instances where severe losses did not emerge were typically instances where market internals improved enough to shift the return/risk profile to a different and more favorable classification. Accordingly, we remain highly defensive here, but the immediacy of our concerns would be reduced if market internals and credit spreads were to improve.
So the question is typically not “whether,” and the question of “when” is unpredictable in the short run and forgotten in the sheer scope of what happens over the completion of the cycle. There is always a question of what investors will focus on as the catalyst for market losses, yet even the “what” is largely irrelevant, and is typically identified after the fact anyway. After the 1987 crash, investors blamed an unfavorable trade balance report as the reason behind the crash. The trade balance really had nothing to do with it, except for being the most unfavorable economic report that could be found in the vicinity of the crash.
Significant news items tend to concentrate selling decisions that contribute to abrupt losses, but those losses are already inevitable once valuations become extreme. In the current cycle, the catalyst might be European bank leverage (which is the main reason Greece is a concern), credit concerns related to covenant lite junk debt, economic weakness, investor concern about monetary shifts, or possibly by wholly unanticipated events. But the “catalyst” will merely affect the timing of the losses.
This is not a Goldilocks market. No, this is a Roseanne Roseannadanna market (Gilda Radner’s character from Saturday Night Live). Though investors seem to believe that catalysts for a market plunge should be known ahead of time, they’re likely to learn in hindsight that the specific catalyst didn’t matter. History teaches that once obscene valuation is coupled with overvalued, overbought, overbullish extremes, and is then joined by deterioration in market internals, the outcome is already baked in the cake. Afterward, investors discover “Well Jane, it just goes to show you… It’s always something. If it’s not one thing, it’s another.”
Understand that now. Once extreme valuations have been established, further market gains have always been transient. Once market internals deteriorate, it’s a signal that investors have shifted from risk-seeking to risk-aversion. At that point, there is no specific event that must be known in advance. One need only have an appreciation for the inevitable swing of the pendulum from extreme euphoria to extreme fear that has characterized the financial markets for centuries. The “catalyst” is rarely appreciated as a catalyst until after severe market losses have already occurred, and in many cases, that catalyst is simply an event that concentrated selling plans that were already being contemplated. If it’s not one thing, it’s another. But it’s always something.
The message here is not “sell everything.” The message is to understand where we are in the market cycle from the standpoint of a century of reliable evidence, and to act in a way that meets your investment objectives. Align your portfolio with careful consideration for your tolerance for losses over the market cycle; with your willingness to miss out on interim market gains should they emerge; with the horizon over which you will actually need to spend from your investments; with the extent that you believe that history is actually informative for making investment decisions; with the extent to which alternative investment outlooks are supported by evidence, ideally spanning numerous market cycles.
Henny Youngman used to tell a story about a guy who hears a little voice in his head singing “Go to Las Vegas.” So the guy immediately turns his car around and heads for Las Vegas. The voice sings “Go to the roulette table.” The guy goes to the roulette table. The voice sings “Put $10,000 down on red.” The guy puts $10,000 down on red.
He loses. The voice says, “Hey, how ‘bout that?”
I shared that story with readers in mid-2007 as the market approached its peak before the global financial crisis, noting:
“Investors are hearing a thousand little voices here telling them to ‘ride the bull,’ that stocks have a ‘floor’ under them, and that valuations are cheap. Whatever risks investors choose to take, they would do well to recognize that if those risks go terribly wrong, most of those little voices will be passive observers with nothing to say but ‘Hey, how ‘bout that.’”
“There are clearly points where the market has speculative merit on the basis of broad market action and favorable internals, even if valuations don’t provide much investment merit. But there are also points where investment merit is clearly absent and speculative trends become strikingly overextended. Then the only reason for speculating is that investors are speculating. On average, those periods turn out badly.”
It really a NYC scam to lure stupid sheeple and when the pen is full, they spring the trap and have a feast. The four-flusher mountebanks call it “sheering the sheep’ or a “haircut”.