Hussman Market Comment

Artificial intelligence is advancing at a stunning, and perhaps uncontrolled speed. Last week, Evan Hubinger, the Alignment Science Lead at the AI company Anthropic estimated a greater than 10% chance that AI could eliminate humanity within a decade. Jakub Pachocki, Chief Scientist at OpenAI, recently observed 'The core problem in AI research is that of alignment - getting the AI to ‘try to do the right thing’ by human standards… An aligned AI should act with honesty and integrity, and love for humanity. This raises a question that is both practical and deeply human, and exactly for that reason, one we cannot afford to exclude from the design of AI: Can we teach artificial intelligence not simply to pursue objectives, but to look deeply enough to act with compassion, and even wisdom?

If you look deeply into a speculative bubble, you can already see the collapse. If you look deeply into a market collapse, you can already see the bull market. The road up and the road down are the very same road. Even so, aside from knowing that our investment position presently requires a safety net regardless of shorter-term conditions – we have utterly no opinions, preferences, or scenarios about the market outlook even a month or a quarter from now. Given present market extremes, yes, we’re about twice as likely to be defensive as constructive, but even here, we expect our investment stance to be constructive about 20-30% of the time. We’ve been briefly constructive even since mid-May.

The current level of stock market valuations remains – easily – the most speculative extreme in U.S. financial history, beyond both the 1929 and 2000 extremes. Our baseline estimate is that the S&P 500 has a material risk of losing something on the order of 75% over the completion of this cycle. Still, we can use historically-informed valuation measures and risk estimates without making our investment stance dependent on any of them. Mountain, cliff, or ocean in the distance, we choose our footing for the terrain beneath us. Rather than attaching ourselves to forecasts and views, we’re content to respond with our best mindfulness as the evidence changes.

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.