There is a particular 'setup' that we’ve historically found to be associated with abrupt 'air pockets' and 'free falls' in the S&P 500. It combines hostile conditions in all three features most central to our investment discipline: rich valuations, unfavorable market internals, and extreme overextension. The potential for this sort of event isn’t a forecast so much as a regularity that should not be ruled out.
My impression is that the current market advance is a narrow and selective speculative blowoff - a bear market rally driven by fear of missing out on the resumption of a bubble that is actually in the early stage of collapse - and that the equity market is likely to suffer profound losses over the completion of the full market cycle.
The greater the misalignment between financial quantities and economic quantities, the more distorted and grotesque the whole picture becomes, particularly if nobody carefully connects the dots. Unfortunately, investors and policy makers repeatedly insist on learning that the hard way.
Departures from systematic monetary policy distort behavior in ways that cause misalignments between financial quantities and real economic quantities, and as a result, they invariably produce damage as the two are ultimately realigned.
The simplest thing that can be said about current financial market and banking conditions is this: the unwinding of this Fed-induced, yield-seeking speculative bubble is proceeding as one would expect, and it’s not over by a longshot.
The Semi-Annual Report of the Hussman Funds for the period ending December 31, 2022 is now available. The report includes a detailed Letter to Shareholders and current outlook as of February 10, 2023, as well as extensive information including investment performance, portfolio holdings, fees, and expenses.
The extreme “tail” risk ahead may be disorienting. While nothing in our discipline relies on valuations to retreat anywhere near their historical norms, we view a market loss on the order of -60% as likely. The February comment examines profit margins, interest rates, monetary policy, growth, and the composition of the S&P 500. All of these have been used as ways to “justify” today’s elevated valuations, and all of them are problematic.
The problem with speculation is that there’s usually a gap between the underlying risk and the inevitable outcome. The gap is most dangerous when there are potential rewards for pushing your luck.
Whether we examine the projections of Wall Street analysts, or the pricing behavior of options traders, investors seem to have ruled out tail-risk - the risk of extreme market losses. Both of have historically behaved as contrary indicators.
Year-to-date market losses have retraced the frothiest segment of the recent speculative bubble, yet our estimates of prospective returns for a passive 60% S&P 500, 30% Treasury bond, 10% T-bill portfolio are nowhere near levels that we would associate with satisfactory long-term returns. Presently, market conditions reflect neither what we would consider "investment merit" nor "speculative merit."