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Hussman Weekly: The Data-Generating Process

October 22, 2012
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According to Ned Davis Research, stock market capitalization as a share of GDP is presently about 105%, versus a historical average of about 60% (and only about 50% if you exclude the bubble period since the mid-1990’s). Market cap as a fraction of GDP was about 80% before the 73-74 market plunge, and about 86% before the 1929 crash. 105% is not depressed. Presently, market cap is elevated because stocks seem reasonable as a multiple of recent earnings, but earnings themselves are at the highest share of GDP in history. Valuations are wicked once you normalize for profit margins. Given that stocks are very, very long-lived assets, it is the long-term stream of cash flows that matters most – not just next year’s earnings. Stock valuations are not depressed as a share of the economy. Rather, they are elevated because they assume that the highest profit margins in history will be sustained indefinitely (despite those profit margins being dependent on massive budget deficits – see Too Little to Lock In for the accounting relationships on this). In my view, there are red flags all around.

Ultimately, what benefits stocks is a movement from being utterly loathed to being highly desired. Once that has occurred – once stocks are overvalued, overbought, and investors are overbullish, one has to rely on the idea that even more eager investors will enter the fray, and take those shares off the hands of already speculative holders. In general, the data-generating process produces the extreme of an advance exactly at the same time that it produces the highest confidence about the continuation of the advance. It produces the extreme of a decline exactly at the same time that it produces the greatest fear about the continuation of the decline. As a result, the point that investors are most inclined to think about the market in terms of the “trend” is exactly when they should be thinking about the market in terms of the “cycle.”

Keep in mind that the bear-market portion of the market cycle typically wipes out more than half of the gains achieved during the bull-market portion. During “secular” bear market periods, the cyclical bear markets wipe out closer to 80% of the prior bull market advances. Risk-management is very forgiving of missed gains in late-stage bull markets. The lack of risk-management is equally punishing to investors who overstay.

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