John Hussman: The Diva Is Already Singing

A note on evidence-based investment discipline: It will come as no surprise that we continue to encourage a patient, historically-informed strategy that aligns our investment stance with the estimated return/risk profile of the market at each point in time. A century of evidence demonstrates the effectiveness of this discipline both from the standpoint of return versus a passive investment approach, and from the standpoint of diminished risk. Yet this is also a discipline that has been decidedly wrong more recently. We have some explaining to do.

Part of a good investment discipline is, and must be, to constantly seek improvements and address challenges. But part of a good investment discipline is also to recognize those points where discomfort is an unpleasant necessity. An “improvement” that might ease discomfort by reversing our presently defensive stance, but that would have left investors vulnerable to the deepest market losses on record, is no improvement at all. We tolerate the frustration of remaining defensive during this speculative advance because it shares hallmarks that were shortly followed by the most punishing market losses in history. The fact that a similar consequence has been deferred in this instance does not convince us that it has been avoided.

It’s important to understand why we so adamantly adhere to our approach, having missed not only recent gains, but larger gains since 2009. The reason is simple: a significant portion of our miss in this cycle traces to what I view as a necessary stress-testing decision in 2009 that had the very unfortunate effect of foregoing returns that either our pre-2009 methods or our present methods could have captured. I’ll leave the fine points of this to prior commentaries of recent years, as I’m told that I make this distinction too often. I actually doubt that’s possible. The stakes of failing to understand this distinction are far too high – particularly now.

As I’ve frequently noted, the most dangerous points to embrace risk are typically when a syndrome of overvalued, overbought, overbullish conditions emerges. In contrast, the most favorable points to embrace market risk typically occur when a moderate-to-severe retreat in valuations is followed by an early improvement in market action, as measured across a broad range of market internals (an opportunity that we easily accepted in early 2003 after the 2000-2002 bear market). The benefit of these considerations is straightforward to demonstrate in numerous complete market cycles across history, even using very simplistic factors – see Aligning Market Exposure with the Expected Return/Risk Profile.

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Bubble Update

Regardless of last week’s slight tapering of the Federal Reserve’s policy of quantitative easing, speculators appear intent on completing the same bubble pattern that has attended a score of previous financial bubbles in equity markets, commodities, and other assets throughout history and across the globe.

The chart below provides some indication of our broader concerns here. The blue lines indicate the points of similarly overvalued, overbought, overbullish, rising-yield conditions across history (specific definitions and variants of this syndrome can be found in numerous prior weekly comments). Sentiment figures prior to the 1960’s are imputed based on the relationship between sentiment and the extent and volatility of prior market fluctuations, which largely drive that data. Most of the prior instances of this syndrome were not as extreme as at present (for example, valuations are now about 35% above the overvaluation threshold for other instances, overbought conditions are more extended here, and with 58% bulls and only 14% bears, current sentiment is also far more extreme than necessary). So we can certainly tighten up the criteria to exclude some of these instances, but it’s fair to say that present conditions are among the most extreme on record.

This chart also provides some indication of our more recent frustration, as even this variant of “overvalued, overbought, overbullish, rising-yield” conditions emerged as early as February of this year and has appeared several times in the past year without event. My view remains that this does not likely reflect a permanent change in market dynamics – only a temporary deferral of what we can expect to be quite negative consequences for the market over the completion of this cycle.

(click to enlarge)

The late stage of every speculative advance is littered with novel valuation measures intended to show that the old valuation metrics no longer apply. Most of these are very easy to confront with existing evidence. Sometimes, though, good arguments emerge that force us to dive deep into the data to figure out what might be useful. Whether we agree or disagree with a particular argument, we always have great respect for analysts who test their methods in decades of data, and show their work. A few pieces deserved special attention this week.

One involved an argument relating to the Shiller P/E (the S&P 500 divided by the 10-year average of inflation-adjusted earnings). While I often quote the Shiller P/E as a “shorthand” for other measures of valuation, we use a broad range of valuation measures in practice, and all of the most reliable ones are quite extreme at the moment. Still, the Shiller multiple has been a particular target of late, with one recent article offering a particularly good challenge. I won’t spoil the ending here, as Bill Hester has done a nice job of forensic data analysis to show what’s going on in his research article this week Does the Cape Still Work?. Suffice it to say that the Shiller P/E survives the challenge nicely.

A second bit of analysis is from the same thoughtful analyst, who alternately goes by the alias of Jesse Livermore and Arthur Schopenhauer. This one also took some analysis figure out what’s going on. The argument, which can be nicely shown in post-war data, is that the 10-year return on the S&P 500 is over 90% correlated with the ratio of total stock market capitalization to the sum of stock market and (essentially) bond market capitalization. That’s about the same correlation we get from good fundamentally-based models, but in this case, no fundamentals are being used. The argument is essentially that investors become accustomed to certain “preferred allocations” and that market valuations change over time in order to bring that about.

Now, we know that the ratio of stock market capitalization to nominal GDP is already about 85% correlated with subsequent 10-year market returns even omitting dividend contributions, and we can easily factor those in to improve the relationship. Still, the correlation of the average equity allocation with subsequent 10-year market returns was intriguing. On further analysis, if one does the math, the mean reversion in the average investor equity allocation only explains about half of the total variation in market returns, which is unusually low for a good fundamental indicator. What’s going on is that the appearance of market capitalization in the denominator of the average investor allocation mutes the volatility of the indicator, but retains the overall correlation with subsequent returns. Examining the data, it turns out that the sum of equity and bond market capitalization is very smooth because bonds dominate. So variations in total equity market capitalization, compared with a relatively smoothly growing benchmark, are really what drive the correlation.

Put simply, higher market capitalizations – relative to any reasonably smooth benchmark that grows somewhere close to the rate of nominal GDP – are associated with lower subsequent market returns. That should not be a surprising outcome, and there are a dozen ways to demonstrate this very robust historical fact. The regularity simply reflects the fact that equities are a claim on a very long-term stream of future cash flows, and equity prices are much more volatile than the rather smooth discounted value that those cash flows represent.

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