Hussman Market Comment

If you look deeply into a speculative bubble, you can see the market collapse in it. If you look deeply into a market collapse, you can see the bull market in it. Each is a continuation of the other.

In recent years, our most reliable measures of stock market valuation have pushed beyond their 1929 and 2000 peaks, and I’ve described the period since early 2022 as the extended peak of the third great speculative bubble in U.S. history. In my view, that process is now complete. The stock market faces severe downside risk ahead, and the U.S. is constrained in the unsystematic monetary and fiscal expansion that both amplified that bubble and fueled record but wholly impermanent corporate profit margins. Meanwhile, the U.S. economy now faces an imminent recession, and if we fail to be vigilant, we, once united Americans, risk losing what is far greater and more valuable than money.

With regard to the record ratio of financial market capitalization to GDP, the government deficits of the past eight years have bloated the corporate profits on which investors are placing extreme price/earnings multiples while calling it 'stock market capitalization.' Meanwhile, the highest income earners have also accumulated the cash and securities that the government issued to finance the deficits. As a result, the massive deficits of recent years are a significant portion of what the deepest pockets presently call 'wealth.'

It’s enormously tempting to imagine, at bubble highs, that glorious backward-looking returns, far greater than those previously implied by valuations, demonstrate that historical standards of value are outdated and obsolete. In 1934, Benjamin Graham and David Dodd described the mood surrounding the 1929 market peak, observing that investors had abandoned their attention to valuations because 'the records of the past were proving an undependable guide to investment.' For the moment, neither valuations nor arithmetic matter to investors. As Galbraith observed, 'As long as they are in, they have a strong pecuniary commitment to belief in the unique personal intelligence that tells them that there will be yet more.'

On Friday December 6th, the U.S. stock market pushed to the most extreme level of valuation in U.S. history, based on the measures that we find best-correlated with subsequent S&P 500 total returns, as well as the depth of subsequent losses over the completion of market cycles across a century of data. That’s not a forecast. Rather, it’s a statement about current, measurable, observable market conditions.

Change is the sum of fundamental trends, the gradual elimination of accumulated extremes, and the random arrival of new shocks. This is true for nearly every process, including economic growth and stock market returns.

One of most dangerous habits of a speculative crowd is the tendency to use unconditional averages and unconditional probabilities regardless of how extreme market conditions have become. This is like stepping into a house with two rooms, one with the temperature at 0 degrees and one at 140 degrees, and expecting a temperature of 70 either way.

It's the wrong question to ask, "How can we somehow force internals to look like trend-following measures that aren't as reliable across history?" Happily, abandoning that question frees us to ask a better question. Once one accepts that internals are, in fact, behaving as intended, the question becomes: "How can we benefit during bearish conditions when valuations and internals validly hold us to a defensive outlook, yet obvious but less reliable trend-following measures remain favorable?" As John Dewey wrote, a problem well-stated is half-solved.

The key takeaway is that attending directly to market internals is actually more effective than attending to monetary easing or tightening. Still, given that we can expect a pivot toward lower rates in the near future, how much do valuations tend to increase, on average, in the 3, 6, 12, and 24 months following a Fed pivot? The answer is simple. They don’t.