“Wall Street remains exuberant about economic prospects. Last week brought a 6-year high in consumer confidence, evidently supporting the idea that the consumer remains strong and the economic expansion remains intact. Unfortunately, if you examine the data, you'll quickly discover that consumer confidence is a lagging indicator, well explained by past movements in GDP, employment, and capacity utilization. Worse, for the stock market, it's a contrary indicator. This is a fact that I've noted at both extremes, not only in early 2000 when new highs in consumer confidence supported a defensive position, but conversely in the early 1990's, when new lows in consumer confidence supported a leveraged position in stocks. High levels of economic optimism are regularly observed at the peaks of both U.S. and foreign economic expansions. This includes the general consensus of individuals, businesses, politicians, central bank officials and notoriously – economists. That shouldn't be surprising. It's the very nature of a peak that it can't be produced except by unusual optimism.”
Hussman Weekly Market Comment, 08/06/07Â Strong Economic Optimism (… is a Contrary Indicator)
Confidence abounds. Last week, Investor’s Intelligence reported a surge in advisory sentiment to the highest bullish percentage since October 19, 2007. The National Association of Active Investment Managers (NAAIM) reported that the 3-week average equity exposure among its members increased to the highest level on record. We observe warnings from nearly every variant of overvalued, overbought, overbullish, rising-yield conditions that have accurately warned investors of oncoming market losses in a century of data, not to mention in real-time in 2000 and 2007 (see for example, my October 2007 comment Warning – Examine all Risk Exposures).
As one of many historically effective variants of this syndrome, define “overvalued” as a Shiller P/E anything higher than 18 (given an actual multiple of 25.7 here, any objections to the Shiller metric are quibbles); define “overbought” as the S&P 500 at least 8% over its 200-day average, and just to be extreme about it – within 2% of a 5-year high; define “overbullish” as a 2-week average of bulls greater than 54% with bears less than half that level – below 27%; define rising yields as a 10-year Treasury yield higher than it was 6 months earlier.
Prior to 2013, those conditions were observed only in June 2007 – about 2% from a bull market peak that would be followed by a 55% market loss; July 1999 – when optimistic investors could at least look for the S&P 500 to advance another 8% to the ultimate bull market peak in 2000, after which the market lost half its value – but not without a 12% correction between July and October 1999 first; the August 1987 pre-crash peak; the December 1972 peak, a few weeks before the New York Times quoted then-analyst Alan Greenspan saying “It’s very rare that you can be as unqualifiedly bullish as you can now” – immediately followed by a 50% market plunge; and (using imputed sentiment data) August 1929.
The deeply unfortunate part of this story is that since early 2013, these strenuously overvalued, overbought, overbullish, rising-yield conditions have been observed not only in recent weeks, but also in May 2013, with a close call as early as February 2013. No material market weakness has emerged during this period, which encourages investors to ignore the risk altogether, rather than consider the likelihood that this risk is increasing, despite being unrealized to-date.
Investors are unusually prone to abandon sound investment disciplines at market extremes, because the one-directional nature of the prevailing trend makes anything but permanent extrapolation seem like a bad bet. Our own stress-testing miss earlier in this half-cycle doesn’t help in that regard. I’m quite aware of how willing investors are to dismiss objective evidence here simply by pointing to the unfortunate miss that attended my fiduciary response to Depression-like risks. That miss was unrelated to the present ensemble of evidence – now validated across a century of history – that concerns us here. I’ve detailed this narrative dozens of times, and these are distinctions that are best understood sooner than later. It's quite late already, and as Rudiger Dornbusch once said, “The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.”
With regard to the ongoing dispute about whether the recent advance can be characterized as a “bubble” in the traditional sense, our own case is detailed in prior commentaries – see in particular An Open Letter to the FOMC: Recognizing the Valuation Bubble in Equities. Meanwhile, I continue to believe that quantitative easing has no mechanistic relationship to the economy or the financial markets beyond creating a purely psychological discomfort with zero interest rates, and encouraging a reach for yield in speculative assets that has already set reckless extremes in median stock valuations, margin debt, and "covenant-lite" lending. Want to know the cause-and-effect mechanism that links QE to the economy? As FOMC governor William Dudley observed last week, so does the Fed.
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