The fol­low­ing para­graphs come cour­tesy of John Hussman’s lat­est weekly newslet­ter, The rub­ber hits the road, and are pub­lished below with the nec­es­sary permission.

“Last week, we observed a sub­tle shift in yield pres­sures, which has his­tor­i­cally been asso­ci­ated with fairly abrupt ‘air pock­ets’ in which stocks have typ­i­cally lost 10% or more within the span of about six weeks. As usual, this isn’t a fore­cast, but given that we are already defen­sive on the basis of broader con­sid­er­a­tions about over­val­u­a­tion and the over­bought sta­tus of the mar­ket, the pres­sures we’re see­ing on the yield front make our aver­sion to mar­ket risk some­what more pointed.

“Con­sider the fol­low­ing con­di­tions: 1) mar­ket val­u­a­tions above their his­tor­i­cal norm by any amount at all — for exam­ple, a div­i­dend yield on the S&P 500 any­thing less than 3.7%, and; 2) The 10-year Trea­sury bond yield and the year-over-year CPI infla­tion rate higher than their lev­els of six months ear­lier (regard­less of whether their absolute lev­els have been high or low).

“If you look at mar­ket his­tory since 1940, this con­di­tion has been in effect nearly 20% of the time. Yet this set of fac­tors alone has made an enor­mous dif­fer­ence in the returns achieved by the mar­ket. When the above con­di­tions have been in effect at the same time, the S&P 500 has actu­ally lost ground on a price basis, and has deliv­ered an annu­al­ized return of just 0.28%. In con­trast, when those con­di­tions have not been in effect, the mar­ket has advanced at an aver­age annu­al­ized rate of 14.94%. Of course, these aver­ages mask a lot of volatil­ity, but it is clear that even the most basic com­bi­na­tion of low stock yields and ris­ing yield pres­sures is hos­tile to total returns.

“To the above con­di­tions, if Trea­sury bill yields are also higher than six months ear­lier (again, regard­less of the absolute level of yields), the annu­al­ized return drops to –0.83%. Add a dis­count rate higher than six months ear­lier, and the annu­al­ized return drops to –2.22%.

“Now add over­bought con­di­tions (say, a 12-month advance in the S&P 500 of greater than 30%), and the annu­al­ized return turns sharply neg­a­tive, to –39.17%. Over­val­ued, over­bought con­di­tions with ris­ing yield pres­sures are trou­ble. Given those con­di­tions, exces­sive bull­ish­ness only wors­ens the sit­u­a­tion. Now, this com­bi­na­tion of con­di­tions has never per­sisted for an entire year, so the actual loss sus­tained by the mar­ket is not so extreme, but suf­fice it to say that the typ­i­cal loss has been in excess of 10%.

“Based on the cur­rent over­bought sta­tus of the mar­ket, there are only three sim­i­lar peri­ods that we can iden­tify in post-war data: August-October 1999 (which was fol­lowed by an abrupt air pocket of greater than 10%), September-October 1987 (no com­ment required), and September-December 1955 (which was fol­lowed by a 10% cor­rec­tion, a brief recov­ery, and a sec­ondary decline to re-test the ini­tial low).

“Again, this is not intended as a fore­cast, but rather to note a his­tor­i­cal reg­u­lar­ity that seems rel­e­vant in a mar­ket envi­ron­ment where we are already defen­sive on the basis of other considerations.”

I have also main­tained that US val­u­a­tion lev­els are a head­wind to stock mar­ket per­for­mance and will become an even big­ger neg­a­tive once the mon­e­tary author­i­ties start remov­ing the “juice”. Although over­all mar­ket returns may not be excit­ing off these lev­els, old-fashioned cherry-picking of indi­vid­ual stocks could still yield good results.

Source: John P Huss­man, Huss­man Funds, March 8, 2010.

Dr. Prieur du Plessis is an investment professional with 26 years' experience in investment research and portfolio management. More than 1,200 of his articles on investment-related topics have been published in various regular newspaper, journal and Internet columns, including his blog, Investment Postcards from Cape Town. He has also published a book, Financial Basics: Investment. Prieur is Chairman and principal shareholder of South African-based Plexus Asset Management, which he founded in 1995. The group conducts investment management, investment consulting, private equity and real estate activities in South Africa and a number of foreign countries. He also serves as Honorary Consul of Slovenia for South Africa, actively developing economic, cultural and scientific relations between Slovenia and South Africa. Prieur is 54 years old and live with his wife, television producer and presenter Isabel Verwey, and two children in Cape Town, South Africa. His leisure activities include long-distance running, traveling, reading, motor-cycling and scripophily. Read more from the author/contributor here.

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