“Keep it simple, stupid,” appears to be the critical message from John Hussman this week as he reminds market participants, once again in his detailed analytical style, that it’s not “different this time,” and in fact it’s considerably worse than it has ever been before…
“Chuck Prince famously said we have to dance until the music stops. Actually the music had stopped already when he said that.“
– George Soros
And Hussman warns the music just ended…
In recent days, the combination of extreme valuations and unfavorable market internals has been joined by acute dispersion in daily trading data that often occurs within a few days of pre-collapse peaks in the market. My opinion is that the music has already quietly faded out like the end of a pop song, in a wholly uneventful way, and that even a surprise push to further highs would be marginal.
Presently, the dispersion we observe in market internals suggests that investors are becoming increasingly selective; that their psychology has subtly shifted away from speculation, and toward risk-aversion. Our own measures shifted negative on February 2, 2018. More recently, the 2% advance of the S&P 500 Index beyond its late-January high has been accompanied by a sharp narrowing of participation and leadership across individual securities. The profound narrowing we observe in daily data, coupled with repeated leadership reversals within a fraction of a percent of the recent market highs, is what amplifies the likelihood that recent valuation extremes will have immediate and severe consequences, as they did after the 2000 and 2007 peaks.
Without making too much of daily data, the following chart shows how unusual is to see large leadership reversals as the market is setting new highs. The chart shows every instance in the past 25 years when the S&P 500 was within 0.6% of a 5-year high, yet the number of NYSE 52-week lows exceeded 4% of issues traded, and stood at least 50% above the corresponding number of new highs.
There’s a perception that bull markets have to go out with fireworks, like a spectacular finale of light and explosion that tells everyone in the most obvious way possible that the show is over, followed by the sound of parents everywhere calling to their children “Get in the van! Get in the van!” in order to beat the crowd. But that’s really only true of “V” tops like 1929 and 1987, where the market advanced by over 30% from correction lows to the final bull market highs. More generally, the final months of a bull market tend to be much choppier events. To the extent that they include a “speculative blowoff,” the excitement is typically restricted to an increasingly narrow handful of stocks, with divergent leadership and ragged participation more broadly. That, of course, is exactly the type of market action we see at present.
The chart below shows the final 200 days leading to the bull market tops of 1973, 2000 (the final high on a total return basis was 9/1/2000), and 2007. Each peak was followed by market losses approaching -50% or more. The advance to the most recent September 20 high is shown for comparison. In each case, price fluctuations in those last 200 days spanned about 15% from low to high, and featured separated retests of the final highs. Our present concerns are based on valuations, market internals, and other factors, but it should be clear that no further “blowoff” is required in order for the recent bull market to establish its peak.
As Hussman explains, it’s all rather simple really – if you just stick to the numbers…
Decades ago, a legendary trader told me “Kid, everything looks easy once you know how it works.” Every field of human endeavor is full of examples where people struggled to solve a problem, yet having done so, the solution looked almost embarassingly obvious in hindsight.
Put simply, in late-2017, we abandoned the idea that there is any definable “limit” to speculative recklessness of Wall Street, as there was in prior market cycles. We now require explicit deterioration in market internals in order to adopt a bearish market outlook, with no exceptions. We can hold a neutral outlook given sufficiently extreme conditions, but whenever uniformly favorable market internals indicate that the speculative bit is back in their teeth, our willingness to adopt or amplify a negative market outlook drops to zero. Most often, when our measures of market internals are uniformly favorable, our market outlook will be constructive as well.
Likewise, our measures of valuation correctly identified extremes in 2007 and today, and identified the market as undervalued in late-2008 and 2009, which I observed in real-time. It’s a profound mistake to imagine that valuations or market internals have become less effective in navigating market cycles. There’s no evidence to that effect.
Then Hussman takes aim at the real cause of this utter delusion – The Federal Reserve’s monetary policy
…the current back-slapping about the success of extraordinary monetary policy is a lot like declaring victory in a football game at halftime, just before a flock of fire-breathing dragons swoops onto the field and eats the leading team. As we saw in the collapse of the mortgage bubble (another product of yield-seeking speculation brought to you by your friends at the Federal Reserve), we have to allow for the possibility that the second half of the game will be violently unrecognizable.
I describe recent Fed policies with the word “deranged” intentionally – not just because those policies took interest rates and the monetary base far outside of their historical range, but also because doing so has encouraged an even more grotesque round of yield-seeking speculation than the preceding mortgage bubble, which ended in global financial collapse. In the interest of protecting the jobs of bank executives, and protecting bank bondholders from perhaps a few hundred billion dollars in losses (depositors were never at risk, which should be immediately obvious from studying any bank balance sheet), the Fed created yet another yield-seeking bubble that has encouraged vastly expanded indebtedness in every sector of the economy, and has set U.S. equity market investors up for a likely loss in excess of $20 trillion in market capitalization in the coming years.
A $20 trillion market loss?
Preposterous. The audacity – nay – the temerity, as Gary Gulman would say. Unfortunately, that’s how valuations work over the complete cycle. That’s how it was possible to correctly project an -83% loss in tech stocks in March 2000, and a loss in the S&P 500 of about -50% at the 2007 peak. When you’re pushing $40 trillion in U.S. equity market capitalization, the highest multiple of U.S. GDP in history, a loss of half of that capitalization over the completion of the cycle is a conservative estimate. It’s certainly not a worst-case scenario. Also, remember from the 2000-2002 and 2007-2009 collapses that Fed easing does nothing to provoke speculation in periods where investors are risk-averse, because in a risk-averse environment, safe liquidity is a desirable asset rather than an inferior one.
Finally, Hussman concludes ominously: “this will end badly.”
Again, the only way to produce bubbles like 1929, 2000 and today is for speculation to continue despite lesser extremes. That doesn’t mean that valuations have failed. It means that speculation has persisted for longer than usual, and that the devastating consequences of hypervaluation are still ahead. Someone has to remain willing to say that out loud. The financial markets are in a bubble. It will end badly.
Given current valuations, even a return to average run-of-the-mill historical norms would result in a loss of about two-thirds of U.S. stock market capitalization. Meanwhile, any significant recession will likely be accompanied by a wave of corporate bankruptcies in a system where corporate debt is easily at the highest percentage of corporate gross value-added in history, and the median corporate credit rating is already just one notch above junk.
With respect to the financial markets, Hussman warns that present conditions already encourage a highly defensive, even hard-negative investment outlook. Evidence of an oncoming recession is not needed as a condition for a defensive position. To the contrary, a significant market decline will be among the factors that will warn of an oncoming recession.