Dancing at the Edge of a Cliff (Hussman)

Sunday, May 13th, 2012

In recent weeks, I’ve emphasized that our estimate of prospective market return/risk in stocks has slipped into the most negative 0.5% of historical data (reflecting a range of horizons from 2 weeks to 18 months). Last week that estimate actually deteriorated, but I am reluctant to make comments on such a small sample, as the only more negative estimate in post-Depression history was on September 16, 2000. Even in the conditions that match the worst 2% of our return/risk estimates (which is the part of the tail we have been in since late-February), the market has lost an average of 20-25% just in the following 6-month period. As much as I try to maintain equanimity – focusing on the average outcome of a particular set of market conditions rather than the specific instance at hand – it is very difficult to do so at present.

The green bands in the chart below depict all of the points since 1980 in the neighborhood of present conditions – having a nearly similar prospective return/risk profile, coupled with a particularly hostile “exhaustion syndrome” that has been a hallmark of the worst market outcomes in recent decades. The blue line shows the S&P 500 Index. As I noted in Goat Rodeo, “what this combination picks up is an already fragile set of market internals that has enjoyed an ‘exhaustion rally’ that both exceeds earnings growth and is met with overbullish sentiment.”

I usually show longer-term charts, but there are no green bands prior to 1987. Before that point, valuations were never been as extended as they are today – on the basis of normalized earnings – except in the quarters leading up to the 1929 crash. Exhaustion syndromes prior to 1987, while still very hostile to stocks, didn’t occur in valuation conditions as rich as we have today. It’s worth noting that there is a very narrow band in 2006 that was followed by a decline of only a few percent, but even the seemingly benign instances in 1998 and early 2000 represented losses exceeding 10%. I suspect we’re at risk of something far more significant. Importantly, the drivers of our market risk estimates are largely independent of our measures of recession risk. This may provide some insight into why my concerns have become so strident in recent weeks.

Present market risks involve a confluence of factors. First, valuations remain unusually rich. Though prospective returns are better than at the 2000 and 2007 peaks, valuations remain more elevated than at any point prior to the late-1990′s bubble, save for the period before the 1929 plunge. Notably, valuations only seem “reasonable” on the basis of “forward operating earnings” if one ignores the fact that profit margins are 50-70% above historical norms, and are dependent on unsustainably large fiscal deficits and depressed household saving in order for that to continue (see Too Little to Lock In).

Second, market internals have deteriorated, with an uncomfortably familiar “two-tier” profile developing between a handful of speculative momentum stocks and the broader market. Coupled with an active new issues calendar, near-panic levels of selling by corporate insiders, heavy beta exposure among mutual funds and institutional managers, record-low mutual fund cash levels, and advisory bearishness at just 20.5% (a level last seen before the steep 2011 decline), there appears to be a lopsided exposure to risk among speculators, and a divestment among issuers.

Third, as I’ve frequently noted, the best way to extract meaningful signals and reduce noise in volatile data is to draw those signals from the joint behavior of several indicators. While these methods range from the simple to the complex, we’ve frequently presented variously defined sets of indicators (see An Angry Army of Aunt Minnies) that capture some particular investment environment (such as an overvalued, overbought, overbullish market where favorable drivers have begun to drop away). In recent weeks, we’ve seen several of these hostile syndromes emerge, as I’ve detailed in prior weekly comments.

Tags: Earnings Growth, Equanimity, Exhaustion, Goat, Hallmark, Horizons, Hussman, Instances, Market Internals, Market Outcomes, Present Conditions, Quarters, Risk Estimates, Risk Profile, Rodeo, Sentiment, September 16, Term Charts, Valuations, Worth Noting That
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No … Stop … Don’t. (Hussman)

Monday, April 16th, 2012

As of Friday, the S&P 500 was at about the same level as at the end of February. I noted then that our estimate of potential market losses over an 18-month window was in the worst 1.5% of historical observations. More recently, we’ve observed a marked deterioration in our measures of market internals. As a result, our estimate of potential market losses over a 6-month window is now in the worst 0.5% of historical observations. In particular, we’re seeing a very broad-based downward shift in market action across nearly every industry group. While the depth of the breakdown is still fairly shallow, the uniformity of the signal suggests significant information content (for more on this distinction, see the note on extracting economic signals from multiple sensors in Do I Feel Lucky?). Though our market concerns are independent of our economic concerns, we see essentially the same downward uniformity in leading economic measures across the industrialized and developing world (for example, see the charts near the end of last week’s comment Is the Fed Promoting Recovery or Desperation?).

Of course, our risk estimates are based on the average market outcomes that have followed similar evidence over the past century, and this particular instance may be different. Regardless, I remain in the uncomfortable position of having to express our concerns with the word “warning.”

This is not an appeal for investors to sell, or even reduce their investment exposure, but is rather an appeal for investors to carefully examine their exposure to market risk, and to consider their willingness to adhere to their existing investment discipline through a steep and potentially extended market decline. We are enormous advocates of investment discipline, but we also know how uncomfortable that can be during various points of the market cycle. For buy-and-hold investors, the main thing to examine is the extent of loss you can tolerate without abandoning that strategy, in recognition of the actual size of the losses that investors have regularly experienced over time. It is best to ask that question when you are experiencing strength. You never want to be in a position of abandoning a sound long-term discipline because of discomfort over some portion of the market cycle.

I have no desire to persuade investors to abandon their discipline or make major changes to their portfolio allocations if they have considered the potential risks carefully. That consideration should include a careful examination of the declines that stocks have experienced on several occasions since 2000, because as I’ve detailed in numerous prior comments, present valuations are much closer to those that have accompanied historical market peaks than those that have marked durable troughs. In any case, my job isn’t to convince others of our own investment viewpoint or to nudge investors away from their own particular discipline. My job is to articulate our own as clearly as possible, so our shareholders understand what we are doing and why. Right now, we are white-knuckle, hold-on-tight defensive, because we’ve only seen similar return/risk estimates in the left-most tail of the historical data, and the growing number of hostile indicator syndromes we observe have generally been followed by awful market losses.

I’m quite aware that the investing world has ruled out any possibility of extended market losses thanks to the confident certainty that the Fed is capable of preventing both market declines and economic downturns indefinitely. But even in recent years, the best that these massive interventions have done is to provoke about 6 months of speculative advances and a brief burst of pent-up demand – each time only after the market has suffered reasonably significant losses. We may very well get QE3. But to believe that the hope for QE is itself sufficient to prevent significant losses first is a notion that is not even consistent with the evidence of the past few years.

We remain defensive on the basis of an army of hostile syndromes (typified by the “overvalued, overbought, overbullish, rising yields” combination, but coupled with several others), now joined by a breakdown in market internals – not greatly observable on the basis of depth, but of high concern on the basis of uniformity. We also observe clear evidence of economic softening and recession around the world, and an early deterioration in U.S. indicators as well (though these data points are still dismissed as noise). In short, our concern about market risk persists. Our concern about the risk of an oncoming recession persists. Nothing in the recent data has removed my impression that the period ahead may become an unmanageable Goat Rodeo of market volatility, economic disappointments, sovereign debt concerns, and European banking strains. Our risk measures have been less extreme in about 99% of history, so even if they are incorrect in this instance, we are not likely to persist with such a strongly defensive view for long. I expect that we’ll have good opportunities to accept a constructive investment stance at better valuations and without such extensive headwinds. But with the recent deterioration in market internals, we can’t even see a speculative case for market risk here.

In the classic version of Charlie and the Chocolate Factory, Gene Wilder watches one child after another ignoring every cautionary warning, with predictably bad consequences. His deadpan appeals become increasingly halfhearted and emotionless because he knows they won’t listen anyway. We’re strongly defensive based on historical evidence that is in the most negative 0.5-1.5% of all historical observations, but it’s clear that others are willing to take significant market risk and to chase wildly enamored stocks here, not as part of a long-term investment discipline or as part of a balanced portfolio strategy, but simply as a speculation – in the belief that they’ll be able to take their profits before other speculators do. Our only response to these speculators is to quote Willy Wonka: “I wouldn’t do that. I really wouldn’t. No… Stop… Don’t.”

Market Climate

As noted above, the Market Climate for stocks remains particularly hostile on the basis of a variety of hostile indicator syndromes – particularly the joint overvalued, overbought, overbullish, rising-yield condition at present – as well as a uniform deterioration in market internals. Strategic Growth and Strategic International remain tightly hedged. Strategic Dividend Value is hedged at 50% of the value of its stockholdings, which is its most defensive stance. In Strategic Total Return, we added a few percent to our precious metals holdings on the selloff early last week. The Fund presently has a duration of less than 3 years in Treasury securities, with about 8% of assets in precious metals shares, and about 2% of assets in utilities and foreign currency holdings.

Tags: Buy And Hold, Desperation, Deterioration, Developing World, Downward Shift, Economic Concerns, Economic Measures, Economic Signals, Hussman, Industry Group, Investment Discipline, Market Decline, Market Internals, Market Losses, Market Outcomes, Market Risk, Potential Market, Risk Estimates, Uncomfortable Position, Uniformity
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