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John Hussman: Not In Kansas Anymore

May 20, 2013


On overvalued, overbought, overbullish conditions

Last week, Investors Intelligence reported that the percentage of bullish investment advisors moved to 54.2% (from 52.1% the prior week) with just 19.8% of advisors bearish. The Shiller P/E (S&P 500 Index divided by the 10-year average of inflation-adjusted earnings) reached 24.5. The S&P 500 is well-through its upper Bollinger bands (two standard deviations above its 20 period moving average) on weekly and monthly resolutions, in a mature bull market advance, with 10-year Treasury yields higher than they were 6-months prior.

None of these conditions in isolation has enormous impact; each usually only modifies expected returns. The problem is that when significantly overvalued, overbought, overbullish conditions have been observed together – particularly coupled with rising bond yields – the syndrome indicates a disease that none of the symptoms identify individually.

I’ve noted before that even a Shiller P/E above 18 combined with a wide spread of bulls versus bears at some point during the prior 4-week period is generally enough to outweigh trend-following considerations, such as the S&P 500 being above its 200-day moving average (see Aligning Market Exposure with the Expected Return/Risk Profile). I’ve also noted that some conditions can be more simply defined. For example, instances featuring bearish advisors below 20%, with the S&P 500 at a 4-year high and a Shiller P/E above 18 are limited to the present advance, May 2007, August 1987, December 1972 (though with an early signal in March-May of that year), and February 1966, all which were followed by significant bear market losses.

Various definitions of an overvalued, overbought, overbullish syndrome can capture slightly different instances. Less stringent definitions capture a larger number of danger zones, but also allow more false signals. Still, as long as the basic syndrome is captured, the subsequent market outcomes are almost invariably negative, on average. Presently, what we observe is among the least frequent and most hostile syndromes we identify. As I observed in the weekly comment that turned out, in hindsight, to accompany the 2007 market peak (see Warning – Examine All Risk Exposures):

“There is one particular syndrome of conditions after which stocks have reliably suffered major, generally abrupt losses, without any historical counter-examples. This syndrome features a combination of overvalued, overbought, overbullish conditions in an environment of upward pressure on yields or risk spreads. The negative outcomes are robust to alternative definitions, provided that they capture that general syndrome.”

The chart below highlights each point in history that we’ve observed the following conditions: Overvalued: Shiller P/E anywhere above 18; Overbought: S&P 500 at least 7% above its 12-month average, within 3% of its upper Bollinger bands on weekly and monthly resolutions, and to capture a mature advance, the S&P 500 well over 50% above its lowest point in the prior 4 years; Overbullish: a two-week average of advisory bulls more than 52%, and advisory bears less than 28%. Rising yields: 10-year Treasury yields higher than 6-months earlier. The instance in 1929 is based on imputed sentiment data, as bullish and bearish sentiment is correlated with the extent and volatility of prior market fluctuations.

One of the difficulties with this sort of analysis is that instances that appear to be very clear peaks on an 85-year chart are actually periods where there was often a cluster of instances with further market advances for several more weeks. In 1929, the market advanced another 5% to its final peak in the two weeks following the first instance of this syndrome. In 1972, the market advanced a final 3% over 6 weeks. The 1987 and 2000 peaks occurred the same week that the syndrome emerged. In 2007, the S&P 500 advanced to within 2% of its final peak 3 weeks after this syndrome emerged, and crawled within 1% of that peak after 9 weeks. The S&P 500 then dropped nearly 10% over the next 4 weeks, and then staged a final 11% spike over 8 weeks to a marginal new high which actually marked the 2007 peak. In 2011 the market enjoyed a choppy 6% advance, dragged out over 16 weeks, before rolling into a 19% correction over the following 12 weeks. The present signal reiterates the first one that we observed in late-January, 17 weeks ago. To a long-term investor, this is the blink of an eye, but in the context of day after day of bullish euphoria, it seems like an absolute eternity.

In general, the initial decline from these peaks tends to occur as a sharp 6-10% market drop over a handful of weeks, typically followed by a partial recovery attempt toward the prior peak. This sort of activity both before and after major peaks gives the market the impression of near-term “resilience” that dilutes the resolve even of investors who know the history of these things.

I should note that present conditions are extreme enough that neither trend-following nor momentum factors can be used to separate out favorable outcomes from this small set of decidedly unfavorable ones. As I’ve previously noted, a great deal of our research during this advance has focused on this sort of “exclusion analysis.” I recognize that many investors have simply decided on the strategy of holding stocks until QE ends, or some similar formulation of “strategy,” but for better or worse, we do insist on approaches that we can validate in historical and out-of-sample data, and that have been strongly effective over full market cycles. When we examine the past few years, as well as long-term history, the most effective “exclusions” aren’t simple ones like “don’t fight the trend” or “don’t fight the Fed.” Rather, they are more subtle prescriptions like “stay with the trend in an overvalued market, but only until overvalued, overbought, overbullish conditions are established.” These considerations aren’t actually required to do well over complete market cycles, but quantitative easing has held off the resolution of historically unfavorable market conditions much longer than usual, and these subtle considerations would have undoubtedly made recent experience less frustrating.

If this bull market is to continue, I have little doubt that considerations like this will provide the opportunity to be constructive on the basis of well-tested evidence that actually supports a constructive stance. Here and now, a constructive stance is an experiment about whether QE can override market conditions that have always preceded unfortunate outcomes. My views and research should be of no impediment to investors with a different view, assuming that they have a reliable exit criterion that will precede the attempts of tens of millions of others to exit. It would be far easier to conduct that experiment without me than to convince me that it is a good idea.

As the respected technician Bob Farrell once noted, “exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.” This is really all the 1987 crash was – a mass of investors trying to preserve profits from the preceding advance by acting on the identical trend-following exit signal simultaneously.

On valuations

Even in the event that quantitative easing is sufficient to override hostile market conditions in the near-term, it is worth noting that long-term outcomes are likely to be unaffected. We presently estimate a prospective 10-year total return on the S&P 500 Index of just 2.9% annually (nominal). See Investment, Speculation, Valuation and Tinker Bell for the general methodology here, which has a correlation of nearly 90% with subsequent 10-year market returns – about twice the correlation and nearly four times the explanatory power as the “Fed Model” and naïve estimates of the “equity risk premium” based on forward operating earnings.

We presently estimate that the S&P 500 is about 94% above the level that would be required to achieve historically normal market returns. If you work out present discounted values, you’ll find that depressed interest rates can explain only a fraction of this differential, even assuming another decade of QE – and even then only if historically inconsistent assumptions are made to combine normal economic growth with deeply depressed rates.

This chart gives a good overview of what has actually transpired in the stock market through post-war history. Points of deep undervaluation like 1942, 1950, 1974 and 1982 created foundations on which long secular bull market advances were built. The rich valuations of the mid-1960’s were enough to ensure that any return to undervaluation would result in a long period of poor market returns. The late-1990’s bubble took valuations far above any historical valuation norm, and ensured that even a return to valuations previously considered “rich” would produce devastating returns, and we saw that in 2000-2002. The advance to the 2007 peak did not go nearly as far, but still ensured that even a return to normal valuations would produce devastating returns, and we saw that in 2007-2009.

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Rating: 2.8/5 (12 votes)


SeaBud premium member - 10 months ago
I don't understand this article on gurufocus - a value website. There are 3 supposed indicators in this article: Shiller p/e, investment advisors and technical analysis. First, as a devote "non-technician", any article with "Bollinger bands" generally has me heading the other way. As this is a "value" oriented website, I think most here agree.

But I read on because it mentioned Shiller P/E - a valuation metric I respect. However, the Shiller p/e is STRONGLY warped by the earnings destruction in '07-09 (especially banks - which were a great investment thereafter as earnings normalize). I suspect the data from the crash years are the abnormality rather than representing future earnings well. Still, this is a red flag to me.

It seems hard to imagine anyone caring what "non-guru" investment advisors say. The only time they are of value is when they are extreme (super negative or super bullish) in which case they do create risks and opportunities if you play off their warping the market. However, it is hard to argue we are at that level when barely over half of managers are bullish and vast numbers of Americans are staying out of the equity markets and buying an asset (Treasuries) that will likely produce a negative return.

I do think many "safe dividend" stocks (P&G, JNJ, Kimberly) are priced well beyond their likely growth so that 2-3% rise in equity value is likely (but you get 3% dividends, so that isn't too bad). But, back to the article, to say that the tea leaves flash "crash" and "extreme" is unpersuasive to this value investor. Caution is in order, especially given the premium placed on certain safe dividend stocks, but if you think WFC is ready to crash at a p/e of 10.5 (and other favorable value metrics), I'd be very surprised (same for Intel, MSFT, Volkswagen, VOD).
Traderatwork - 10 months ago
@SeaBud Absolutely agree with you. This "guru" hussman is a phd in some sort of finance/economy (like the random walk book guy Malkiel or something) and he/they has no idea how to invest and his fund/investors are losing big time, you can check out his "performance" on his own website.

Don't worry about you don't agree or understand all his jargon - I don't and I'll rather invest my time understanding Ben Graham articles that written 50 or 60 years ago or all things written by Buffett. This guy definitely a pass, unless he can show us 10 years 15% annual compound return. Which I suspect it will be never if he keep doing/believing he is right...
Vgm - 10 months ago

Perhaps you're new around here, but if you look back, you'll discover, inexplicably and amazingly, that Hussman has a significant fan club on GuruFocus, despite his lowly track record. In fact, he embodies all that Munger and Buffett scorn in economic soothsayers.

I'm with you and Trader. For me Hussman personifies the chasm between academic 'analysis' and the real world of value investing. He should be spending every minute of his waking day trying to learn how to evaluate businesses, and create value for his clients, instead of pontificating incessantly on the inherently unknowable.

"If your financial advisor starts talking technicals, zip up your purse and walk away." Buffett
Shaved_head_and_balls - 10 months ago
Actually the "E" in the Shiller P/E is inflated by the fact that Standard & Poors removed failed banks like Lehman, Bear Stearns, Washington Mutual, etc. from their index and replaces them with companies with higher earnings than would have occurred if the insolvent banks were saved by the government. Market indices have a survivor bias that inflates the earnings over time. Chances are that many "value investors" on this website have underperformed the S&P 500 because they bought owned the now defunct banks that traded at phony low valuations.

The banks earnings were broadly inflated in the runup to 2008. It was a bubble in real estate and banking. The inflated pre-2007 earnings were balanced out by the losses in the aftermath.
LwC - 10 months ago
Hussman Weekly: A Reluctant Bear's Guide to the Universe

Posted by: GuruFocus (IP Logged)

Date: February 4, 2013 09:31AM


"I’m keenly aware that the reflexive answer to these concerns is to disregard the messenger. After all, here's a guy who had compiled a great record by early-2009 (anticipating a market loss which incidentally erased every bit of return achieved by the S&P 500 in excess of Treasury bills, all the way back to June 1995), and yet, seemingly unable to invest his way out of a paper bag during the recent bull market advance. Fair enough – I don’t deny for a second that my insistence on making our discipline robust to extreme economic and financial uncertainties also shot us in the foot in the recent bull market upswing – but that unfortunately doesn't alter the objective evidence, or the severity of present conditions. ",207183,207232#msg-207232

Gurufocus premium member - 10 months ago
When John Hussman loses his last fan, the market will peak. He has certainly lost a lot of them already.
AlbertaSunwapta - 10 months ago
I regularly read Hussman's writings and always find something interesting and potentially valuable in them. And as I've said before, I find it hard to knock a manager that tries to protect his investors capital by keeping an eye on overall market conditions particularly so when overall market conditions are substantially influenced by government and central bank policy (post-2007) or lack of it (pre-2007) both in the US and in large emerging markets like China.

Unfortunately conventional hedging is costly and requires that ever elusive near perfect market timing and seems to have turned Hussman satisfactory longterm returns into mediocre returns.

In terms of his value to me the reader, just as Buffett has on several occasions added to my understanding of expected returns based on market aggregates, Hussman too has helped me understand this market in terms of a historical perspective.

BTW, I've been very uneasily selling into this market and now have a cash position like no prior time excepting my cash levels mid-2008 (85%). I think Hussman's evidence has swayed me slightly towards this bias. Cash is my hedge.
AlbertaSunwapta - 10 months ago
I wonder if Howard Marks reads Hussman.

“If you are a value investor and you invest whenever you find a stock which is selling for one-third less than your estimate of intrinsic value, and you say, I don’t care about the macro, nor what I call the temperature of the market, then you are acting as if the world is always the same and the desirability of making investments is always the same. But the world changes radically, and sometimes the investing world is highly hospitable (when the prices are depressed) and sometimes it is very hostile (when prices are elevated).

“I guess what you are saying is we just look at the micro; we look at them one stock at a time; we buy them whenever they are cheap. I can’t argue with that. On the other hand, it is much easier to make money when the world is depressed, because when it stops being depressed, it’s like a compressed spring that comes back.

"…I think it is unrealistic and maybe hubristic to say, ‘I don’t care about what is going on in the world. I know a cheap stock when I see one.’ If you don’t follow the pendulum and understand the cycle, then that implies that you always invest as much money as aggressively. That doesn’t make any sense to me. I have been around too long to think that a good investment is always equally good all the time regardless of the climate." - Howard Marks
Batbeer2 premium member - 10 months ago
>> On the other hand, it is much easier to make money when the world is depressed, because when it stops being depressed, it’s like a compressed spring that comes back.

I remember 08/09.

It wasn't easy.
Vgm - 10 months ago

Noteworthy value investors, both past and present, do not invest based on macro predictions. If you have made investment decisions based on Hussman's prognostications, then that's your lookout. But you needn't go as far as Hussman since CNBC has the same negative predictions on a daily basis.

Here are some quotes which may be of interest:

A. “We have two classes of forecasters: Those who don’t know - and those who don’t know they don’t know.” John Kenneth Galbraith

B. "Oaktree's Six Principles of Investing Strategy

Number 5. Macro-forecasting is not critical to investing

The Oaktree team takes the view that consistently excellent performance can only be achieved through superior knowledge of companies and their shares. Attempts at predicting what is in store for the economy, for interest rates, or for the stock market in general is of no help in this regard. Again, a bottom-up, company-specific, research-based approach is encouraged.

This echoes the oft-quoted views of highly successful investors such as Warren Buffet and Peter Lynch"

Howard Marks

C. "Charlie and I don’t pay attention to macro forecasts. We have worked together now for 50 years and can’t think of a time we made a decision on a company where we’ve talked about macro. We don’t know what things will look like in precise way. Naturally we think if we don’t know that nobody else knows. Why spend time talking about something you don’t know anything about? People do it all the time. But it’s not very productive. So we talk about the businesses." Warren Buffett

D. “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in the corrections themselves.” Peter Lynch

E. “The function of economic forecasting is to make astrology look respectable.”

John Kenneth Galbraith (and often repeated by Buffett and Munger)

F. "We will continue to ignore political and economic forecasts which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%. But surprise - none of these blockbuster events made even the slightest dent in Ben Graham's investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist." Warren Buffett

G. “In the business world, the rearview mirror is always clearer than the windshield.” Warren Buffett

H. “The stock market has predicted nine out of the last five recessions.” Paul Samuelson

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