Speculative Extremes and Historically Informed Optimism- John Hussman

The weekly view from John Hussman

Author's Avatar
Jul 25, 2016
Article's Main Image

There’s a field in one of our data sets that rarely sees much play, being driven primarily by only the most extreme combination of overvaluation, overbullish sentiment, and overbought conditions we’ve identified across history. It’s one of a variety of such syndromes we track, and I’ve simply labeled it “Bubble,” because with a single exception, this extreme variant has only emerged just before the worst market collapses in the past century. Prior to the advance of recent years, the list of these instances was: August 1929, the week of the market peak; August 1972, after which the S&P 500 would advance about 7% by year-end, and then drop by half; August 1987, the week of the market peak; March 2000, the week of the market peak; and July 2007, within a few points of the final peak in the S&P 500, with a secondary signal in October 2007, the week of that final market peak.

The advancing segment of the current market cycle was different in its response to historic speculative extremes. Air-pockets, panics and crashes had regularly followed these and lesser “overvalued, overbought, overbullish” extremes in every previous market cycle, and our reliance on that fact became our Achilles Heel during the advancing half of this one. In an experiment that will ultimately have disastrous consequences, the Federal Reserve’s policy of quantitative easing intentionally encouraged yield-seeking speculation in this cycle far beyond the point where these warning signals emerged.

In other cycles across history, patient adherence to a value-conscious, historically-informed investment discipline was rewarded, if occasionally after some delay. In the advancing portion of this cycle, Ben Bernanke’s blind, stubborn recklessness made patient adherence to a value-conscious, historically-informed investment discipline itself indistinguishable from blind, stubborn recklessness. In mid-2014, we adapted our own investment discipline to address this challenge (see the “Box” in The Next Big Short for the full narrative). While lesser overvalued, overbought, overbullish syndromes in 2010 and 2011 were followed by significant market losses, the pattern changed once the Fed drove short-term interest rates to single basis points. In the face of these near-zero interest rates, one had to wait for market internals to deteriorate explicitly (indicating a shift toward risk-aversion among investors) before adopting a hard-negative market outlook.

In a series of signals between late-2013 and the beginning of 2014, that rare “Bubble” signal emerged again. This time, however, it was accompanied by quantitative easing, a Treasury bill yield averaging just 0.03%, and uniform market internals across a broad range of individual stocks, industries, sectors, and security types (when investors are inclined to speculate, they tend to be indiscriminate about it). The S&P 500 retreated, but by just 3%, followed by an advance for several more months until market internals deteriorated early in the second-half of 2014. Since then, the broad market has essentially gone sideways, though capitalization-weighted indices such as the S&P 500 have recently clawed to new highs on enthusiasm about negative interest rates abroad (which I believe actually reflect fresh deterioration in global economic conditions across Britain, Europe, Japan, and China).

Last week, market conditions joined the same tiny handful of extremes that defined the 1929, 1972, 1987, 2000 and 2007 market peaks. Still, the false signal near the start of 2014 (and lesser extremes before then), helpless in the face of single basis-point Treasury bill yields and uniform market internals, encourages a certain level of humility and flexibility.

It’s clear that at least between late-2011 to mid-2014, the Fed engineered an environment that disrupted the typical response to extreme and previously reliable warning signs. In 2010 and 2011, lesser overvalued, overbought, overbullish extremes were followed by significant market losses, even though Treasury bill yields were only in the range of 10-15 basis points. In contrast, between late-2011 and mid-2014, T-bill yields averaged less than 5 basis points, and the majority of the intervening market gains overlapped the roughly one-third of that span when our present, adapted measures would encourage a constructive outlook (largely on the basis of favorable market internals). Currently, Treasury bill yields are about 30 basis points (higher than in 2010 and 2011), and while certain trend-following measures are favorable here, our overall evaluation of market internals is still mixed. Put simply, the mitigating factors are weaker here, but it’s not entirely clear what happens next.

continue reading: http://hussmanfunds.com/wmc/wmc160725.htm