John Hussman: Baked In The Cake
- Bernard Lasker, NYSE Chairman, 1972, just before the market fell by half in the 73-74 plunge
“The danger of mispricing risk is that there is no way out without investors taking losses. And the longer the process continues, the bigger those losses could be. That's why the Fed should start tapering this summer before financial market distortions become even more damaging.”
- Martin Feldstein, President emeritus, National Bureau of Economic Research, July 1, 2013
The U.S. equity market is now in the third, mature, late-stage, overvalued, overbought, overbullish, Fed-enabled equity bubble in just over a decade. Like the 2000-2002 plunge of 50%, and the 2007-2009 plunge of 55%, the current episode is likely to end tragically. This expectation is not a statement about whether the market will or will not register a marginal new high over the next few weeks or months. It is not predicated on the question of whether or when the Fed will or will not taper its program of quantitative easing. It is predicated instead on the fact that the deepest market losses in history have always emerged from an identical set of conditions (also evident at the pre-crash peaks of 1929, 1972, and 1987) – namely, an extreme syndrome of overvalued, overbought, overbullish conditions, generally in the context of rising long-term interest rates.
Despite individual features that convinced investors in each instance that “this time is different”, the corresponding handful of truly breathtaking market losses in history have a single source: the willingness of investors to forego the need for a risk premium on securities that have always required one over time. Once the risk premium is beaten out of stocks, there is no way out, and nothing that can be done about it. Poor subsequent returns, market losses, and the associated destruction of financial security (at least for the bag-holders) are already baked in the cake. This should have been the lesson gleaned from the period since 2000, but because it remains unlearned, it will also become the lesson of the coming decade.
The coming 10-year period will likely include two or three bull markets, and two or three bear markets. Still, at the end of that decade, I expect that the S&P 500 Index will be little changed from its present level, having achieved an average annual total return of less than 3%, nominal, including dividends, with a number of deep interim market losses along the way. This isn't even a dire forecast. It's the central expectation based on valuation approaches that have a near-90% correlation with subsequent 10-year returns in close to a century of market data.
With respect to the present, mature, overvalued, speculative half-cycle, I don't expect this cycle to be completed with a 20% loss, or a 25% loss, but instead a loss in the 40-55% range. Again - this isn't even a dire forecast. A 40% market loss is the central expectation. Even run-of-the-mill bear markets average a loss of about 32%, while run-of-the-mill cyclical bear markets in a secular bear context average a loss closer to 38%. It’s all well and good to say that the market advance since 2009 has fully recovered the 55% loss of the 2007-2009 bear market – as long as you also realize those gains. Otherwise, the recent market advance will ultimately be nothing but a forgotten parenthetical remark in a dismal investment story stretching from 2000 to some point late in this decade. I have particular concern about those who are coming into the market at these levels on the idea that the market is safe because it keeps going up. Bank of America notes that institutional investors have never dumped as much stock onto the public than they have in the past four weeks. Margin debt remains at historic levels, exceeding 2.3% of GDP for only the third time in history - the other two times, not surprisingly, being at the 2000 and 2007 market peaks.
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