“Almost everyone believed that speculation could be now resumed in earnest. A common feature of all these earlier troubles was that having happened they were over. The worst was reasonably recognized as such. The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to ensure that as few as possible escaped the common misfortune. The man with the smart money, who was safely out of the market when the first crash came, naturally went back in to pick up bargains. The bargains then suffered a ruinous fall."
J.K. Galbraith, The Great Crash
“Is our profession really so lazy that we would advise people to risk their financial security based on tinker-toy models and pretty pictures that we don't even have the rigor to test historically? Investors appear eager to ‘scoop up’ so-called ‘bargains’ on the belief that stocks are ‘cheap relative to bonds.’ All of this is predicated on the belief that profit margins will remain at record highs, that the Fed Model is correct, and that P/E ratios based on extremely elevated measures of earnings should be evaluated based on norms for much more restrained measures of earnings. Based on daily closing prices, the S&P 500 has not even experienced a 10% correction, yet the recent decline has been characterized as if investors are acting ‘like the world is about to end.’ This is not the pinnacle of human irrationality, but in fact, quite a shallow selloff from a historical standpoint. The fact that Wall Street is branding it otherwise is evidence that investors have completely forgotten how deep the market's losses can periodically become.”
Hussman Weekly Market Comment, August 2007
Long-Term Evidence on the Fed Model and Forward Operating P/E Ratios
“Given the damage already wrought on the Nasdaq, there is a natural inclination to buy the dip. We believe that there is little merit in doing so. The current market climate is characterized by extremely unfavorable valuations, unfavorable trend uniformity and hostile yield trends. This combination is what we define as a Crash Warning, and this climate has historically occurred in less than 4% of market history. That 4% of market history includes the 1929 crash and the 1987 crash, as well as a number of less memorable crashes and panics. We prefer to hedge until there is a rational prospect for market gains. When valuations are favorable, stocks are attractive from the standpoint of ‘investment’ – meaning that stock prices are attractive compared to the conservatively discounted value of cash flows which will be thrown off in the future. When trend uniformity is favorable, stocks are attractive from the standpoint of ‘speculation’ – meaning that regardless of valuation, investors are displaying an increased tolerance for risk which favors a further advance in prices.”
Hussman Investment Research & Insight, November 2000
If there is a single pertinent lesson from history at present, it is that once obscenely overvalued, overbought, overbullish market conditions are followed by deterioration in market internals (what we used to call “trend uniformity”), the equity market becomes vulnerable to vertical air-pockets, panics and crashes that don’t limit themselves simply because short-term conditions appear “oversold.”
I should immediately add the most pertinent lesson that we’ve learned from our own challenges in the half-cycle advance since 2009. After correctly anticipating the global financial collapse, and even shifting to a constructive outlook after the market plunged by more than 40% in late 2008 (see Why Warren Buffett Is Right and Why Nobody Cares), the out-of-sample behavior of the economy and the financial markets – from the standpoint of postwar data – led me to insist on stress-testing our methods of estimating market return/risk profiles against Depression-era data. The methods that emerged from our stress-testing effort performed better across history, and in holdout data, better than anything we had previously developed. While they included our measures of “trend uniformity,” they also picked up an additional regularity. In prior market cycles across history, the emergence of an extreme overvalued, overbought, overbullish syndrome regularly accompanied or closely preceded deterioration in market internals. As a result, we took a negative market outlook as soon as those overvalued, overbought, overbullish syndromes emerged. If the Federal Reserve’s program of quantitative easing made one thing “different” in recent years, it was to intentionally encourage yield-seeking speculation despite those overbought extremes. That disrupted the historical tendency for “overextended” features of market action to closely precede deterioration in “trend-sensitive” features of market action. One had to wait until market internals had actually deteriorated explicitly before taking a hard-negative outlook. That’s the condition we imposed on our methods in mid-2014.
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