Hussman Market Comment

The essential feature of a useful alternative asset isn’t that it’s unusual or exotic, but that its returns aren’t tightly linked to the risks that already dominate the portfolio. The value of an alternative asset comes from the way it interacts with the other assets in the portfolio. The lower the correlation, particularly if the asset tends to hold value or advance when the rest of the portfolio is under pressure, the more the asset can improve the expected return/risk profile of the portfolio – even if the ‘standalone’ return on that asset may be low.

What to do? Does one capitulate and chase the bubble at the highest valuations in history? Does one wring their hands at the prospect of a bubble that might only go higher and higher forever without end? My hope is that this month’s comment will offer both perspective and confidence that it is not necessary to chase current extremes, nor to be anxious even about the possibility of steeper ones. “Loving the bubble” doesn’t mean taking risks that rely on the bubble to be permanent. Instead, it means finding more flexibility in our outlook, ideally with a safety net in periods we’re able to be constructive. We can now apply that flexibility to a larger set of constructive instances. Now is still not one of them.

The defining feature of a Ponzi scheme is that it persuades investors to pay for future cash flows that, at least in part, don’t actually exist, while creating the impression that those cash flows imply an attractive return on the price investors pay. If we look carefully at the record valuation extremes in the equity market, and the wildly elevated profit margins that investors appear to view as permanent, we can already see the potential for difficult, even tragic outcomes for investors. Thus far, conditions have not been sufficient for those outcomes. We’ve adapted the implementation of our discipline in recent years, to the point where nothing in our discipline requires a retreat in valuations. That doesn’t mean leaving ourselves vulnerable to that sort of outcome, but it does mean that we’ve found ways to embrace even a perpetually expanding bubble, without discrimination.

The word 'equilibrium' is an invitation to recognize that nothing exists by itself, alone. Subject and object are two sides of the same coin – their interaction is a single phenomenon. That perspective can offer a great deal of insight about economics, financial markets, speculative bubbles, passive investing, and nearly everything in existence.

To love a bubble but hate a crash is to misunderstand the market. A bubble is a crash on its way to becoming. A crash is a bull market on its way to becoming. All we can do is to accept, and as difficult as it may be – embrace – whatever form we have in the present moment, so we can do our best with each of them. We don’t need the bubble to be eliminated. We don’t need to grind our teeth until the future arrives to replace the present. There’s nothing we need to discard. Taken together, I expect we have more than we need to benefit – happily – in the event of a never-ending speculative bubble, and that we’ve retained all the proper defense we need to defend against whatever collapse may eventually arrive.

The defining feature of every bubble is the same: a growing inconsistency between the long-term returns that investors expect in their heads - based on extrapolation of the past, and the long-term returns that properly relate prices to likely future cash flows - based on valuations. Every bubble smuggles the same tragic past into the same tragic future by packaging it with new wrinkles that convince investors that this time is different. Ultimately, they still end the same way.

The S&P 500 stands at the most extreme level of valuations in history. This record aligns precisely with the happiest and most satisfying moment of a speculative bubble: the point where wildly misaligned expectations for market returns are being realized anyway – via self-fulfilling speculation. From an equilibrium standpoint, record corporate profits and free cash flow, particularly as a share of GDP, are the mirror image of record deficits in the government and household sectors. This isn’t a theory. It’s an accounting identity. Sustaining record corporate surpluses requires sustaining record government and household deficits.

Division by zero is known as a 'singularity.' It’s the point where equations break down, values become 'indeterminate,' things stop working normally, and variables shoot toward infinity and suddenly collapse on the other side. The current speculative bubble was driven by a singularity. Avoiding the crash on the other side relies on the willingness of investors to accept the lowest long-term return prospects in U.S. history, forever. Extremely high prices may seem like a beautiful thing, but they’re a corrupt bargain. Unless you actually sell, the cost of “enjoying” record high valuations is that you are locking-in record low future rates of return.

Bubbles are generated when investors drive valuations higher without simultaneously adjusting expectations for future returns lower. In other words, the defining feature of a bubble is inconsistency between expected returns based on price behavior and expected returns based on valuations. The “Bubble Term” measures the gap between the two. Unless the Bubble Term is able to become exponentially larger forever – it shows up as a growing gap between the long-term return that investors expect in their heads, and the long-term return that investors can actually expect based on the future cash flows that will ultimately be delivered into their hands.

With our most reliable stock market valuation measures at the highest extremes in U.S. history, record negative readings on our most reliable 'equity risk premium' gauge (estimated S&P 500 total returns vs. Treasury yields), and the narrowest junk bond risk premiums in history, it’s useful for investors to remember that a market crash is nothing but risk-aversion meeting a market that is not priced to tolerate risk. Emphatically, nothing in our investment discipline relies on a market collapse, or even a reversion of valuations to levels anywhere near historical norms. Particularly with the hedging implementation we introduced last September, I expect it will be enough simply for the market to fluctuate.