A Blast from the Past

In his most recent commentary on the stock market, John Hussman makes a few important observations. Very often, bubble-like advances in financial asset prices can become far more extended than rational, sober observers think possible. One result of this is that those who are warning that the situation is inherently unsustainable are often dismissed as “perma-bears” not worth heeding anymore. It is certainly a label Hussman has been stuck with, although it is simply not true (he is known for taking constructive stances on the market when valuations and /or constructive market internals suggest they are appropriate).

The important point is however this: the warnings (which are both fundamentally and technically based in Hussman’s case) do not become less important when a bubble stretches further, but more so. Moreover, a greater overshoot does not create a “cushion” that ensures that one cannot lose. It merely creates conditions that are more likely to eventually produce an all the more pronounced reaction. Here are a few pertinent excerpts from Hussman’s update:

“The lesson we’ve drawn from recent years is not that historically reliable valuation measures are no longer useful. It’s  not  that overvalued, overbought, overbullish conditions can persist indefinitely without awful consequences. It’s not that “this time is different” in some way that cannot be accounted for with historically-informed methods.

The primary difference between the half-cycle since 2009 and prior market cycles across history is that overvalued, overbought, overbullish conditions have been extended to further extremes, without a material correction, for a much longer period than usual as a result of yield-seeking speculation. The central lesson we’ve drawn is about the criteria that distinguish when the consequences of overvalued, overbought, overbullish extremes may be deferred, and when those consequences are likely to emerge with a vengeance.

[…]

We now observe conditions under which the belief that “this time is different” has historically been most likely to implode.

There’s really no point in trying to convert anyone to our viewpoint. Somebody will have to hold stocks over the completion of the present cycle, and encouraging one investor to reduce risk simply means that someone else will have to bear it instead. But for those who understand the narrative of the recent half-cycle, where our challenges have been, and how we’ve addressed them, I do encourage reviewing all risk exposures from the standpoint of the losses that have repeatedly occurred over the completion of market cycles that have reached valuations anywhere near current levels (1929, 1972, 1987, 2000, and 2007). The point is not to discourage stock holdings entirely, but rather to ensure that exposure is not so large that a steep market loss would be intolerable. It’s important to recognize that the market is not only at a point where unusually rich valuations are already in place, but also where market internals and our measures of trend uniformity have clearly deteriorated. This is the most hostile set of market conditions we identify, and it closely overlaps periods in which the stock market has been vulnerable to abrupt air-pockets, free-falls, and crashes.

So much for what is Hussman’s by now well known assessment of the situation. One of the points we have emphasized above explains why the inevitable denouement of financial asset bubbles always does great damage: in the aggregate, investors cannot escape the coming losses. For every seller there must be a buyer, and those who “panic first” will simply transfer the pain of losses to others.

What we found especially interesting though was the “blast from the past” Mr. Hussman included in his update. He discusses the well-known (at least to market historians) pre-1929 crash warning uttered by Roger Babson. In fact, Babson’s speech in 1929 triggered a short term sell-off that later became known as the “Babson break”. However, the market seemed to immediately recover again from this sell-off, causing Babson’s warning to be blown off (what market participants didn’t know: the very top had been put in just two days earlier). What is especially interesting though is that this was actually the third warning Babson had uttered in as many years: by the time 1929 rolled around, he was no longer taken seriously. He had warned and lamented for three years, and the market had only moved higher after all. It is well worth contemplating this historical example though, as it is relevant to every asset bubble. As Hussman recounts:

“Babson, whose first rule of investing was to “keep speculation and investments separate,” is known not only for founding Babson College in Massachusetts, but also for a speech at the National Business Conference on September 5, 1929, at the peak of the market, saying “sooner or later a crash is coming, and it may be terrific.”

The back-story, however, is that Babson’s presentation began as follows: “I’m about to repeat what I said at this time last year, and the year before…”

The fact is that Babson had been “proven wrong” by an advance that had taken stocks relentlessly higher during the preceding years. Over the next 10 weeks, all of those market gains would be erased. From the low of the 1929 plunge, the stock market would then lose an additional 75% of its value by its eventual bottom in 1932 because of add-on policy errors that resulted in the Great Depression.”

Hussman concludes as follows:

“[...]be careful in believing that a market advance “proves” concerns about valuations wrong. What further advances actually do is simply extend the scope of the potential losses that are likely to follow.  That lesson has been repeated across history. The chart below offers a visual of this story, and may serve as a useful reminder that valuation concerns are generally not durably proven wrong by further advances, particularly when market valuation concerns have been ignored for a long while.”

This is excellently illustrated by a chart bringing Babson’s warnings into context with the advance of the late 1920s and the extent of the subsequent decline.

The DJIA from 1924 to 1932. Babson’s warnings are indicated by the yellow arrows. Note that within a mere ten weeks after the third warning, the market had declined to the level it inhabited at the time of the first. Another two years later it had lost another 75% from the crash low. This is by the way not meant to indicate that something exactly similar is likely to happen. We don’t know that, and it seems in fact unlikely for a variety of reasons. But losing a few years of gains in a flash? That can most definitely happen – click to enlarge.

The Current Market Situation

Of course the above does not mean that a market crash is necessarily imminent. Trying to pinpoint such an event is basically a mug’s game, since by definition, the peak can only occur once and will only be identifiable with certainty in hindsight.

What we can however do is assess market risk more generally. The fact that the market’s advance has been driven by a near doubling of the US money supply since 2008 courtesy of the Federal Reserve is the basic datum that tells us why it is – in fact, must be – a bubble.

Note here that “earnings per share”, which are usually used to assess valuation are distorted, as they are influenced by massive stock buybacks. In the course of these buybacks, corporate balance sheets have deteriorated significantly. Although corporations hold record amounts of cash (in the aggregate, i.e., the data are heavily skewed by a handful of outliers), it is perhaps less well known that their net debt is at a record high too. Moreover, the most indebted companies are not identical with those holding the most cash.

We mention these points merely to make clear that the situation is actually more tenuous than it looks based on a number of key data, even though these data already look quite stretched as well (for instance, the median stock has never been as overvalued as it is today – not even in 2000).

We hold with Hussman that it is immaterial whether the market peaked three weeks ago or whether it resumes its rally after the current downturn concludes: in the latter case, the future “stored up” losses would merely become greater. Naturally, the precise sequence of events is not immaterial to short term traders, but it should be to longer term oriented investors. The latter should focus on risk and reward over the full market cycle, not merely on what happens over the next few weeks or months. Having said all that, the market currently looks quite iffy in the short term as well:

We mentioned in our update on Monday that the market’s seeming reversal at the end of last week felt “suspect” to us. The action over the past few trading days is interesting in this context, as this is the first time in a good while that an “obvious” reversal has failed to stick. Meanwhile, the divergence between big caps and the Russell 2000 has continued to worsen – the ratio has been in a steep downtrend ever since the Russell peaked back in March – click to enlarge.

Meanwhile, looking at high yield bonds, we can see that HYG may well be reversing again from another slightly lower high, in spite of actually outperforming the SPX over the past eight trading days or so. Moreover, the ratio of TLT to HYG (an admittedly imperfect proxy for credit spreads) has just reached another new high. So another important prop underneath the market is increasingly undermined.

HYG, HYG vs. SPX and TLT vs. HYG. None of this looks particularly comforting at the moment – click to enlarge.

Conclusion:

We know it is a risky market from a valuation, sentiment and market internals perspective. Even though it cannot be known in advance when a downturn will turn into something more than just another short term dip, the backdrop suggests that the risk of that happening has continued to grow. One should also heed the recent sharp decline in inflation expectations (see also our comments on the topic from Monday), which happens to go hand in hand with declining growth momentum of the money supply.

Lastly, in case you are wondering why we have recently increased our market update frequency somewhat: one reason is that the situation “feels” especially dangerous to us at this juncture. It is the totality of the technical and fundamental evidence that makes us think that the situation is more worrisome than usual.

Charts by: John Hussman, StockCharts