Bear Market Insights
"I Don't Care About the Price, Just Get Me Out!"
By John P. Hussman, Ph.D.
"The 'new-era' doctrine - that 'good' stocks (or 'blue chips') were sound investments regardless of how high the price paid for them -- was at bottom only a means for rationalizing under the title of 'investment' the well-nigh universal capitulation to the gambling fever... Why did the investing public turn its attention from dividends, from asset values, and from earnings, to transfer it almost exclusively to the earnings trend? The answer was, first, that the records of the past were proving an undependable guide to investment; and secondly, that the rewards offered by the future had become irresistibly alluring ... The notion that the desirability of a common stock was entirely independent of its prices seems incredibly absurd. Yet the new-era theory led directly to this thesis. If a stock was selling at 35 times the maximum recorded earnings, instead of 10 times its average earnings, which was the pre-boom standard, the conclusion to be drawn was not that the stock was too high but merely that the standard of value had been raised. Instead of judging the market price by established standards of value, the new-era based its standards of value on the market price."
- Benjamin Graham & David Dodd, Security Analysis, 1934.
Excerpted from the May 1998 issue of Hussman Econometrics:
Suppose you own stock. You have decided to be a "long term investor." Stock prices rise to a new all-time high. You feel vindicated. The economy looks great. Although market breadth has deteriorated, your commitment is firm. "I can't afford to keep my life savings out of the stock market." "Buy-and-hold" is your motto.
Then, after a modest rise in interest rates, the market sells off -12.3% in just over 2 months time. Ouch. A correction. Buy on the dip. These things happen from time to time. You're a long term investor. Buy-and-hold is your motto.
Sure enough, prices recover. Somewhat. A 4.8% advance, but already, you think, you're on your way to new highs again. Then, you lose it all in a -10.2% decline. Two months later, you've given back your advance, and you're at a lower low. Alright, another correction. Maybe you buy on the dip. Bargain prices. Buy-and-hold is your motto.
And it's already paying off. A month later, you're up 7.8% from the low. But then a -9.1% selloff takes your portfolio even lower than the first two drops. The market is down -19% overall. You start to question the amount of risk you're taking, but how much lower can it go?
Thank goodness. 15.8% advance over the next few months! Should have bought more on the last decline. Earnings are still growing strongly. You decide not to wait. You buy more on the advance, confident that you'll be rewarded by new highs. Then the market plunges -20% over the following 4 weeks. You stare at your statement and feel sick. You've held on for a year and your reward is a new low in your portfolio. This really is a bear market.
Now some volatility. Up 12% over a few months. Then you lose it all a few months later in another decline. Then another 11% advance, followed by a -12% plunge to a new low. Seven times now, you've seen your portfolio collapse by more than -10%. With every recovery, a fresh disappointment. And the months march on. It's a year and a half since the peak. You've lost nearly 30% of your wealth. Price/earnings ratios look low, but they looked low before the last decline, too. But maybe it's the bottom. After all, the average bear market takes stocks down about 30%. Holding your calculator, you realize how that works. A -30% decline wipes out a 43% gain. Didn't really consider that at the top.
Stocks rebound a little over the next month. Just 6%. You're still clinging to the bottom. Then, the bottom drops out. Not just 10%, or 15%, but a real free-fall. Over the next 6 weeks your portfolio plunges by -27%. You're another -23% down from the previous low! Almost 2 years of nothing but losses! Major ones. You've lost almost half your retirement, now. Half your life savings! And the economy has turned bad. Everybody knows that stocks were overpriced at the top! It was so obvious! Greed. Valuations were so high. Everyone was so optimistic. Why didn't you see it at the time? You decide you can't afford the risk. Sell half. See if things recover, then get back in.
Well, prices do recover. More than 15%. But then you lose it all in another selloff! Another new low! The market has lost half its value! Nine major plunges. Nearly every one to a lower low, and getting worse. This market has no support. Where are the buyers going to come from in an economy like this? People are unemployed. They don't have the income to invest! And certainly not in the stock market. The financial headlines trumpet "The Real Recession is Yet to Come", and "The Coming Dividend Crisis." Some of the less diversified mutual funds are down as much as -80% from their highs! 80%! Every $100 has collapsed to $20. If it could happen to them, it could still happen to you. This is too risky. After all, you think, "I can't afford to keep my life savings in the stock market."
"Better safe than sorry" is your motto.
You've just lived through the 1973-74 bear market. Actual figures. Actual headlines. Not pleasant. At the January 1973 market peak, earnings had hit a new high, and stock prices were selling at a P/E multiple of 20, which is extreme on the basis of record earnings. Over the next 2 years, corporate earnings grew by 56%, yet the market fell by half. The 73-74 bear market teaches that stock prices can decline from extreme valuations even if earnings grow dramatically. Imagine what could happen if both P/E multiples and earnings contract simultaneously (Price = P/E x E). Now suppose they don't. Suppose that earnings surprise everyone by growing by 12% annually over the next 4 years. Suppose the P/E multiple doesn't contract to the historical average 12 times record earnings, but is still a high 18 times record earnings even 5 years from now. Guess what. Even if this happy scenario comes true, stock prices will be at the same level 5 years from now as they are today.
The bottom line. It is uniform trend conditions, and only uniform trend conditions, that have kept us in a constructive position. This is, without question, a market that could fall by half. A 50% decline in the S&P 500 Index would put the P/E multiple at 14, still above the historical average P/E that has been applied to record earnings. Not even undervalued. It would put the dividend yield at just 2.8%, far below the historical average of 4% which has been attained at every bear market low. And as noted last month, even if dividend payouts were boosted to the historical average 52% of earnings, the current dividend yield would be only 1.8%. A 50% market drop would bring it only to 3.6%.
[ Editor's note: In May 1998, the S&P 500 stood at 1112, with the DJIA at 9063. It is important to recognize that overvaluation does not require stock prices to decline. Overvaluation simply means that stocks are priced to deliver unsatisfactory long-term returns. Indeed, the market typically ignores valuation when trends exhibit what we call "favorable uniformity." This uniformity (which can be measured objectively) can sustain an overvalued market for months or even years. It is during those periods when valuations are unfavorable and trends lack favorable uniformity that overvaluation suddenly matters. When interest rates are rising as well, overvaluation generally matters with a vengeance. ]
Excerpted from the December 1999 issue of Hussman Econometrics:
"Near the top of the market, investors are extraordinarily optimistic because they've seen mostly higher prices for a year or two. The sell-offs witnessed during that span were usually brief. Even when they were severe, the market bounced back quickly and always rose to loftier levels. At the top, optimism is king, speculation is running wild, stocks carry high price/earnings ratios, and liquidity has evaporated. A small rise in interest rates can easily be the catalyst for triggering a bear market at that point."- Martin Zweig, Winning on Wall Street, 1986
"The greed itch begins when you see stocks move that you don't own. Then friends of yours have a stock that has doubled; or if you have one that has doubled, they have one that has tripled. This is what produces bull market tops. Obviously no one rationally would want to buy at the top, and yet enough people do to produce a top. It is really quite amazing how time horizons and money goals can change when there are stocks around that are going up 100 percent in six months. Finally it all turns into a marvelous carmagnole that is great fun if you leave the party early."- Adam Smith, The Money Game, 1967
Classic. Classic. The market is in the midst of what will undoubtedly be seen in hindsight as a fantastic speculative frenzy. We're glad to have our portfolios gaining on this advance, and we are keeping our put option positions relatively small, and out-of-the-money. That gives us protection against severe declines, but does not unduly hinder our gains if the market proceeds higher. One thing is certain. This market cycle will be completed by a bear market, and a potentially violent one. Of course, nobody thinks about market cycles anymore. Nobody imagines that stocks can do anything but advance. And in the mania of the present, it is easy to forget the nearly identical ones of the past, and their very, very bitter aftermaths.As manias go, the internet stocks are the most spectacular example. By and large, these companies have no earnings, so their stocks are being priced on the basis of revenues, and phenomenal multiples of revenues at that. The vast majority of these revenues are derived from advertisements. The vast majority of advertisers are other internet companies. And in classic Ponzi style, the vast majority of the money being spent on advertising is being derived from initial public offerings of internet stocks to investors. So the stratospheric prices being paid for internet stocks are ultimately being driven by... the stratospheric prices being paid for internet stocks. Talk about a feedback loop.
But while the internet issues remain the most obvious bubble, the most significant objects of speculation, in terms of market capitalization, are stocks which might be considered "blue chip" technology issues. Consider for example, some of the better growth companies on Wall Street (listed below in order of market capitalization), and you can see how profoundly future earnings growth has been impounded into current prices. While these companies are likely to perform very well as businesses, the performance of the stocks hinges much more delicately on the continued willingness of investors to pay exorbitant valuation multiples. Moreover, the fact that the current P/E multiples are based on record earnings should be some cause for alarm.
Similarly extreme valuations appear in other mega-capitalization stocks such as General Electric, Wal-Mart, Home Depot, MCI/Worldcom and Vodaphone. Why do these multiples matter? Because the market is currently displaying not only extreme valuations, but also poor market action and rising interest rate trends. That complete combination is what we characterize as a "Crash Warning", because that phrase has typically been descriptive of the subsequent market action.
There have only been two times in history that market breadth (as measured by the advance-decline line) has diverged so widely from the performance of the S&P 500: 1929 and 1972. The current breadth divergence now exceeds these previous instances both in extent and duration. With the S&P and Nasdaq near new highs, bonds, utilities, transports and the advance-decline line are all plunging. Indeed, the NYSE advance-decline line is now well below the lows of the late-summer 1998 selloff. In the week ended December 3rd, the Dow soared 297 points, and the Nasdaq vaulted nearly 73 points. Yet on the NYSE, AMEX and Nasdaq markets, more stocks declined than advanced on the week. Just 162 stocks on the NYSE hit new 52-week highs, while 780 hit new lows. So in addition to hypervaluation, the most overwhelming characteristic of the market is lack of uniformity.
Historically, the current combination of market conditions has ultimately led to unusually swift declines in Price/Earnings ratios. So even if earnings hold up, prices can endure harsh plunges. During 1973-74, stock prices plunged by half, even though S&P earnings grew rapidly. Given that the P/E ratio of the S&P is currently over 50% higher than it was at the 1929 and 1972 tops, it is clear that valuation multiples have a lot of room to decline. Herewith, a reminder of what those previous declines had in store for good, blue chip stocks.
Blue Chip Performance: 1929-1932
Blue Chip Performance: 1973-1974
The prelude to these devastating declines was extreme valuation, deep and extended breadth disparity, and rising interest rates. The final advances were dominated by extremely short lists of stocks. Investors didn't care then, either. As Forbes Magazine noted following the 73-74 collapse:
"The Nifty Fifty appeared to rise up from the ocean; it was as though all of the U.S. but Nebraska had sunk into the sea. The two-tier market really consisted of one tier and a lot of rubble down below. What held the Nifty Fifty up? The same thing that held up tulip-bulb prices long ago in Holland - popular delusions and the madness of crowds. The delusion was that these companies were so good that it didn't matter what you paid for them; their inexorable growth would bail you out."
You may recall that we printed that quote last July, just prior to the summer 1998 market plunge. Even then, there was a striking divergence between the broad market and the blue chips, but that divergence has now widened beyond its two most catastrophic predecessors.
Based on the model now in use, the market lost favorable market action in June of this year, by which time the bulk of the rebound from last summer's low had occurred. With valuations extreme, interest rates rising, and market action now strongly unfavorable, the characteristics which were present during the vast majority of the recent bull market are now completely absent.
[ Editor's note: In December 1999, the S&P 500 stood at 1389, with the DJIA at 10878. The NASDAQ peaked above the 5000 level several weeks later. Because valuation and trend conditions may shift from time to time, we encourage clients and shareholders to review our weekly market commentary regularly. ]
Excerpted from the April 2000 issue of Hussman Econometrics:
In recent months, we have made the rather bizarre assertion that the Nasdaq is likely to lose somewhere between 65% to 83% of its value from its recent highs to its ultimate bottom. In the March letter, we reviewed the S&P 500 technology stocks, noting that the P/E on those stocks had reached 70, compared to a 1975-1995 average P/E of just 17. Meanwhile, the price/revenue ratio for those stocks had reached 6.8, compared to a 1975-1995 average of just 1.1.
The argument of the "new economy" crowd? Yes, but they're great companies ("good stocks"), you would have been wrong to be against them ("records of the past had proved an undependable guide to investment"), what drives stocks is not the valuation multiple, but only whether these companies beat earnings estimates ("from dividends, from asset values, and from earnings, to transfer it almost exclusively to the earnings trend"), a "new economy" warrants entirely different valuation methods ("the standard of value had been raised"), and anyway, a stock is worth whatever price investors are willing to pay for it ("the new-era based its standards of value on the market price"). "Hence", as Graham & Dodd recounted about the run-up to the 1929 crash, "all upper limits disappeared, not only upon the price at which a stock could sell, but even upon the price at which it would deserve to sell."
Every security price effectively boils down to assumptions about 1) the expectation of future growth rates, and 2) the expected long term return. Those expectations are embedded in the valuation multiple of the stock. A high valuation multiple may imply either unusually high growth expectations, or the willingness to accept very low long-term rates of return. But an excruciatingly high valuation multiple almost by necessity implies both. In a bubble, those two factors become completely detached from reality, and expectations about future returns become increasingly reinforced not by fundamental data, but by price action alone.
We have frequently noted the detachment of investor expectations from the underlying long-term return on stocks. While polls suggest that investors expect a 19% annual return on stocks over the next decade, the fact is that S&P 500 earnings have grown at just 7% annually, not only over the past decade, but as far back as 1950. If the current P/E of 34 on the S&P retreats to a still above-average level of 17 over the next decade, the S&P 500 will show zero price appreciation over the next 10 years. Recall that the Dow reached 1000 in 1966. In 1982, the Dow bottomed at 777. Zero stock market returns over a long period of time would certainly not be unprecedented.
After the Nasdaq plunge of recent days, the entire thrust of commentary has turned to whether a bottom has been set, or whether we might see a few more days of selling pressure. It is unlikely that Nasdaq investors will be treated so well. We continue to view stocks as being in a bear market, and bear market psychology typically evolves something like this:
"This is my retirement money. I can't afford to be out of the market anymore!"
"I don't care about the price, just Get Me In!!"
"It's a healthy correction"
"See, it's already coming back, better buy more before the new highs"
"Alright, a retest. Add to the position - buy the dip"
"What a great move! Am I a genius or what?"
"Uh oh, another selloff. Well, we're probably close to a bottom"
"New low? What's going on?!!"
"Alright, it's too late to sell here, I'll get out on the next rally"
"Hey!! It's coming back. Glad that's over!"
"Another new low. But how much lower can it go?"
"No, really, how much lower can it go?"
"Mother Bear! How much lower can it go?!?"
"There's no way I'll ever make this back!"
"This is my retirement money. I can't afford to be in the market anymore!"
"I don't care about the price, just Get Me Out!!"
[ Editor's note: In April 2000, the Nasdaq stood at 4572.88 ]
Copyright 1998-2001 John P. Hussman, Ph.D.
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.
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