December 28, 2015
On the Completion of the Current Market Cycle and Beyond
As we look forward to 2016, to following through on our investment discipline over the completion of the current market cycle and beyond, a few recent market comments will serve as a detailed review of our present market and economic outlook:
The summary of this outlook is straightforward. I view the equity market as being in the late-stage top formation of the third financial bubble in 15 years. Based on a century of evidence relating the most historically reliable valuation measures to actual subsequent market returns, neither a market plunge of 40-55% over the completion of the current cycle, nor the expectation of zero 10-12 year S&P 500 nominal total returns, nor the likelihood of substantially negative 10-12 year real returns should be viewed as worst-case scenarios - they are all actually run-of-the-mill expectations from current extremes. Based on the joint behavior of the most reliable leading economic measures (particularly new orders plus order backlogs, minus inventories), widening credit spreads, and clearly deteriorating market internals, our economic outlook has also moved to a guarded expectation of a U.S. recession.
Valuations: With regard to current market valuations, and what we view as the likely prospect of zero nominal and negative real S&P 500 total returns over the coming 10-12 years, see Rarefied Air: Valuations and Subsequent Market Returns and The Bubble Right in Front of Our Faces.
Recession: On the economic front, the basis for my increasing expectation of oncoming recession is summarized in From Risk to Guarded Expectation of Recession.
Fed Policy: On the past and anticipated impact of Federal Reserve actions, see Deja vu: The Fed’s Real Policy Error Was to Encourage Years of Speculation, and Reversing the Speculative Effect of QE Overnight.
Market Internals: Also, to openly recognize the awkward transition that followed my 2009 insistence on stress-testing our methods of classifying market return/risk profiles against Depression-era data, to detail the significant challenges that followed, and to underscore the central lesson involving market internals (lest investors infer the dangerously incorrect alternative that valuations don’t matter or that the Fed can always support the market - notions that should be dismissed even by examining the 2000-2002 and 2007-2009 collapses), see The Hinge, Voting Machine - Weighing Machine, Valuation and Speculation: The Iron Laws, and A Better Lesson than “This Time is Different.”
I’ll emphasize once again that the behavior of market internals across a broad range of individual stocks, industries, sectors, and credit-sensitive securities is a “hinge” that distinguishes bubbles that continue from bubbles that crash; Fed easing that supports the market from Fed easing that proves ineffective; and economic deterioration that stabilizes and recovers from economic deterioration that unravels into recession. While many of our long-term concerns would persist regardless of the behavior of market action (as an improvement in internals at these levels would not make reliable valuation measures any less extreme), the immediacy of our concerns would be substantially reduced in the event that market internals were to improve. Ideally, such an improvement will follow a material retreat in valuations; a combination which has historically represented the best opportunity in the market cycle to shift toward an aggressive exposure to stocks.
Full-cycle market dynamics
From the standpoint of full-cycle market dynamics (which include not just bull market gains but also the bear market losses that have regularly wiped out more than half of the those gains over the completion of the typical cycle), I view two features as most important. First, valuations are the primary driver of long-term market returns. The most reliable valuation measures in market cycles across history are those that mute or otherwise account for cyclical variation in profit margins. As the legendary value investor Benjamin Graham observed, the worst investment losses typically result from the assumption that good business conditions can be priced into stocks as if they are permanent: “purchasers view the good earnings as equivalent to ‘earning power’ and assume that prosperity is equal to safety.”
The second feature, however, is that over shorter portions of the market cycle, the main driver of investment returns is not valuation but instead the willingness or aversion of investors to speculate. Because speculation tends to be indiscriminate, the most reliable measure of a robust willingness to speculate is the uniformity of market action across a broad range of individual stocks and security types. An overvalued market populated with speculators who still have the bit in their teeth will tend to hold up or advance further despite valuation extremes. Because of the Federal Reserve’s relentless and intentional encouragement of speculation in the half-cycle since 2009, even measures of overvalued, overbought, overbullish extremes - which had historically been followed almost invariably by market collapses in prior market cycles - were followed instead by further market advances.
Now that market internals have clearly deteriorated following overvalued, overbought, overbullish extremes, with reliable valuation measures at obscene levels and emerging economic weakness, a century of history suggests that the stock market is vulnerable to the risk of severe losses. Investors should not assume that the “support” that keeps losses relatively shallow during a drawn-out topping process will persist. There’s some truth in the old saying “the bigger the top, the steeper the drop.” Only a few points in history have seen the S&P 500 within 3% of a record high, with both overvaluation and unfavorable market internals during at least 80% of the prior 26-week period. Aside from points in recent months, the other points were major tops in 2007, 2000, 1972, 1969, and 1961, with the only exception being a brief instance in 1998 that was cleared by a shift back to favorable market internals after the Asian crisis (which is partly why our immediate concerns would be eased by a similar improvement).
I really do implore investors who could not comfortably ride out a market collapse similar to 2000-2002 or 2007-2009, or who rely on their assets to finance near-term spending plans, to shift their risk exposure down to a level that could tolerate that outcome. Understand that while valuations have been hostile for years, and while overvalued, overbought, overbullish conditions have repeatedly emerged in the recent half-cycle without effect, the hinge that supported continued gains was a persistent willingness to speculate, as conveyed by uniformly favorable market internals. That support has dropped away. Ignore that key distinction at enormous risk. The market behavior we’ve observed in recent quarters is fully consistent with an extended top formation. With credit spreads predictably widening in successively larger spikes, that formation appears increasingly vulnerable to a steep vertical break of prior support.
Because we’re so systematic in choosing market exposure in proportion to the estimated market return/risk profile, I typically describe the willingness to accept market exposure as “risk-seeking” and the abandonment of that willingness as “risk-aversion.” Even when valuations are elevated, some amount of risk-seeking speculation can be “rational.” Rich valuations imply poor long-term investment prospects, but over shorter horizons, the market can remain elevated or advance further provided there is sufficient uniformity across market internals. Once rich valuations are joined by deterioration in market internals, however, any prospects for further gains are overshadowed by the prospects for vertical losses.
Still, we doubt that most speculators think about the decision to accept market exposure in such a systematic way. On that point, Robert Prechter of EWI offered a brilliant perspective last week to describe the typical behavior of speculators. He observed, “In neither case - buying or selling - is there any thought about taking on risk, rationally or otherwise. In both cases, they are unconsciously acting to reduce risk, thanks to the emotionally satisfying impulse to herd. Herds act to gain sustenance or avoid danger. Gazelles may lope together toward the water hole or dash in a herd from predators. The goal, albeit unconscious, of both types of actions is to reduce risk. Likewise, in market advances speculators herd as if trying to gain sustenance; and in market declines they herd as if trying to avoid getting killed... Subjectively, i.e. in their own minds, speculators perceive greater risk as less risk and less risk as greater risk. That is why they buy in uptrends and sell in downtrends. In the former case, they behave as if the herd is leading them to sustenance, and in the latter case they behave as if the herd is leading them away from danger. Ironically, the truth is wholly the opposite.”
The subtlety, in my view, is that both in uptrends and in downtrends, some tendency to join the herd can be adaptive, and can promote survival, but only when the behavior of the herd is uniform. In contrast, when members of a galloping herd suddenly begin to disperse, leaping and scattering about, it’s the sign of a threat at close range. It’s time to retreat, and quickly. In investing, a bullish herd that drives valuations to a speculative extreme and then begins to disperse is a warning sign of potential collapse. Likewise, a bearish herd that drives valuations to a panic low and then begins to disperse is a sign of opportunity.
In short, the uniformity and divergence of market internals, coupled with the position of valuations, provides an enormous amount of information that should not be ignored, particularly at points when those conditions shift. At present, we observe a herd at the peak of a valuation cliff, where an increasing proportion of the herd is backing away. It's increasingly urgent to dig in one's hooves to keep from dashing over the edge. We can do little for those who insist on remaining in full gallop, imagining that sustenance awaits them ahead.
On the other side of the recklessly speculative advance of recent years is not only the likelihood of brutal market losses, but also tremendous opportunity. I fully expect the S&P 500 to double, and to double again over the coming 10-12 years, and yet I also expect the total return of the S&P 500 over that period to be zero. Both aspects of that expectation are likely because markets move not diagonally but in cycles. How did the S&P 500 trace out a total return of zero between 2000 and the end of 2011? By first losing half its value, then more than doubling, then losing more than half its value, and then doubling again. Across history, extreme valuations have invariably been followed by similar behavior - wide cyclical swings, yet only modest overall returns over the following decade.
After years of Fed-induced yield-seeking speculation that has driven equity valuations to the second most extreme point of overvaluation in history (and the single most extreme point on the basis of median valuations), investors have somehow convinced themselves that this time will be different; that this time the market will maintain at a permanently high plateau. That belief is nothing new - it’s the same delusion that investors have held at speculative peaks across history, refusing to accept the familiar signs of danger until the equally familiar losses were conclusively in hand.Despite current market and economic conditions, don’t imagine for a moment that either our disposition or our outlook for the year ahead is negative. To the contrary, our outlook is one of historically-informed optimism, enthusiasm, and confidence. It’s just that those assessments relate to our own discipline and not to the market in general. That discipline is grounded in a focus on valuation and market action, openly adapted in mid-2014 to further elevate the role of market internals, and validated over a century of market cycles, including the most recent one. If anything, we have even greater confidence in our discipline than we had at either the 2000 or 2007 peaks. That confidence turned out to be a good thing for us, even if the reality of the situation didn’t support the same assessment for the economy or financial markets as a whole.
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. Please see periodic remarks on the Fund Notes and Commentary page for discussion relating specifically to the Hussman Funds and the investment positions of the Funds.
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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