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January 23, 2017

Rare Signatures

John P. Hussman, Ph.D.
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The key to drawing useful information out of noisy data is to rely on multiple “sensors.” Alone, each sensor may capture only a small portion of the true signal, and may not be greatly useful in and of itself. The power comes when the sensors are used together in order to distinguish the common signal of interest from the surrounding noise. For example, a good physician diagnoses a patient by collecting a history and a set of observations from various sensors (tests, measurements, symptoms, and so forth), looking for various “signatures” or combinations of evidence that are consistent with one specific condition or another. More generally, a "signature" is any distinctive combination of features that is associated with a specific identity, condition, or outcome.

The reason that doctors wince when people self-diagnose using the internet is that people tend to focus on individual symptoms rather than looking for complete, well-informed signatures. A single symptom, like headache, can be associated with dozens of conditions, so while it may be an informative piece of evidence, it’s not enough. A single symptom is usually a weak predictor in and of itself, and becomes useful only in the context of other evidence. Because patients focus on isolated symptoms rather than syndromes, doctors regularly receive frantic calls from patients that have self-diagnosed a brain tumor. Yes, a tiny fraction of those patients may actually have a brain tumor, but that diagnosis is confirmed only on the basis of a whole syndrome of other findings.

In the financial markets, useful sensors include valuations, price action, overbought/oversold measures, breadth, leadership, sentiment, credit market behavior, volatility, economic factors, and many others. Prior to the recent half-cycle advance since 2009, our own reliance on “signatures” drawn from multiple sensors allowed us to correctly anticipate the 2000-2002 and 2007-2009 collapses (with accurate loss estimates for both), and the evidence to shift to a constructive market outlook after every bear market decline over more than three decades.

As I've detailed regularly, the emergence of an extreme “overvalued, overbought, overbullish” syndrome of market conditions has historically been a powerful warning against further speculation. In prior cycles across history, the emergence of this syndrome was regularly accompanied or closely followed by deteriorating market internals (an indication of subtle underlying risk-aversion among investors), and a steep market loss would typically follow. In the half-cycle since 2009, our reliance on that aspect of history proved costly, because Fed-induced yield-seeking (“there is no alternative!”) encouraged investors to speculate long after severe “overvalued, overbought, overbullish” syndromes emerged. In mid-2014, we adapted by imposing an additional constraint on our methods: in the presence of zero-interest rates, one had to wait for market internals to deteriorate explicitly before adopting a hard-negative market outlook.

Rare signatures

Presently, Fed policy has achieved “liftoff” from the zero interest rate bound, and despite the recent post-election blowoff, our key measures of market internals remain unfavorable here. Given that environment, my expectation is that the overvalued, overbought, overbullish extremes we presently observe may have harsh consequences, as they have in prior cycles. We’ll defer our immediate concerns if market internals shift to a more uniformly favorable condition, but if anything, we’re seeing a sharp broadening in the number of red flags and warning signals we monitor. I’ve noted in recent weeks that our most extreme variant of “overvalued, overbought, overbullish” conditions has emerged; a secondary signal at a level on the S&P 500 about 4% higher than the syndrome we observed in July. Apart from a set of false signals in late-2013 and early-2014 at the height of zero interest rate enthusiasm, every other instance of this syndrome has been associated with a major market peak, including 1929, 1972, 1987, 2000, and 2007.

Last week, an unusual set of classifiers that we monitor raised red flags, with two of our three “crash signatures” now suggesting the likelihood of a market loss in excess of -25% in the months ahead (the last time these signatures were active was between April-October 2008). This would potentially represent the opening salvo of a more extended completion to the current market cycle. No single variable drives these signatures. Rather, they capture unsual combinations of market conditions that may include offensive valuations, dispersion across market internals, credit market weakness, lopsided bullish sentiment, Federal Reserve tightening, or other features. While these signatures are quantitative, my impression is that there is far more potential for economic and social disruption than appears to be reflected in the current speculative pitch. I should also be clear that these signatures are not forecasts but classifications that we’ve constructed to identify highly unusual events. The difference is that a forecast says “we expect this particular outcome in this specific instance,” while a classifier says “we identify the same signature of conditions that has regularly preceded this particular outcome in the past.” It’s a subtle distinction, but an important one. We needn't rely on forecasts. Rather, we continue to align ourselves with the prevailing evidence at each point in time, and our outlook will shift as the evidence does.

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Please see periodic remarks on the Fund Notes and Commentary page for discussion relating specifically to the Hussman Funds and the investment positions of the Funds.

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Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).


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