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One can go some distance in a mine field without anything blowing up – it’s just that the overall odds aren’t good. For now, market action remains unfavorable, which suggests that the enthusiasm of investors is not yet robust, and further skittishness is possible. But again, there is no particularly strong reason to expect one direction over another over the very short term. In any event, conditions remain poor from a valuation standpoint. Stocks are emphatically not ‘cheap.’
It’s particularly interesting that the forward operating earnings crowd has advanced the notion that stocks are as cheap as they were in 1990. Aside from the problems with forward operating earnings that I’ve previously detailed, this particular argument rests on overlooking the state of profit margins, which were quite depressed in 1990 and are at record highs currently. Think about that for a moment and you’ll see what’s going on. A forward P/E multiple on depressed profit margin assumptions provides at least some margin for error. The same forward P/E based on assumptions of the highest profit margins in history contains no such margin.
– John P. Hussman, Ph.D., August 27, 2007, shortly before the global financial crisis
The problem with speculation is that there’s usually a gap between the underlying risk and the inevitable outcome. The gap is most dangerous when there are potential rewards for pushing your luck.
In July 2007, Chuck Prince, the CEO of Citigroup, famously pushed his luck saying “When the music stops, in terms of liquidity, things will get complicated. But as long as the music is still playing, you’ve got to get up and dance.” The deterioration that would shortly unfold into a global financial crisis was already underway. After years of Fed-induced yield-seeking speculation in mortgage securities, aided by demand from yield-starved investors, and abetted by Wall Street institutions that were all too ready to supply new “product,” the inevitable implosion would produce a 55% loss in the S&P 500, and a 98% loss in the value of Citigroup.
Unfortunately, the rewarding gap between underlying risk and inevitable outcomes can encourage people to persist in reckless behavior. In 2007, the tragic results of that behavior were already baked in the cake. Only the timing was uncertain. As I wrote at the time, one can go some distance in a mine field without anything blowing up – it’s just that the overall odds aren’t good.
The distortions in the financial markets are different today than they were in 2007. This time around, the Fed starved investors of yield for a decade, and much more aggressively. Looking in the rearview mirror, the effects of relentless yield-seeking speculation look glorious. But the unwind may be breathtaking. The distortions in the stock market are far beyond those of 2007, more closely resembling 1929 and 2000. That remains true, even though the bubble peaked a year ago. Since then, the S&P 500 has lost a modest -15.7%, including dividends.
I continue to expect that the unwinding of this bubble will drive the S&P 500 to just one-third of the level it set at its January 2022 peak. I know – that seems preposterous. That’s why I present statements like that with data, as I did before the global financial crisis in 2007, and as I did when I projected an 83% loss in technology stocks in March 2000. Preposterous, yet also unfortunately correct.
Investors often make the mistake of dismissing rich valuations if they don’t result in immediate losses. That’s emphatically not how valuations work. Extreme valuations are not equal to a near-term forecast about market direction. Rather, our investment discipline is to align our outlook with measurable, observable market conditions – including both valuations and market internals – and to shift our investment outlook as those conditions shift. No forecasts or scenarios are required.
Before the current yield-seeking speculative bubble does unwind – 2022 was only a warmup, in my view – recall that the only thing truly “different” about quantitative easing and zero interest rate policy was that it encouraged investors to speculate beyond any well-defined historical “limit,” on the belief that zero interest rates left them with no other alternative. As I’ve detailed regularly, I ultimately abandoned our detrimental bearish response to those “limits,” and I’m pleased that the benefit of those adaptations has become increasingly clear in the past few years.
Valuations and market internals continue to be essential in navigating the complete market cycle. Our most reliable valuation measures remain well-correlated with subsequent long-term returns and full-cycle drawdowns. Indeed, while the average level of valuations has been above historical norms in recent decades, the average level of subsequent returns has predictably been lower than historical norms. It has taken the most extreme yield-seeking bubble in history to bring the total return of the S&P 500 to even 6.27% since its March 2000 peak, much of which I suspect will be wiped out in the next few years. Likewise, the entire total return of the S&P 500 in the most recent market cycle accrued in periods when market internals were favorable.
Investors often make the mistake of dismissing rich valuations if they don’t result in immediate losses. That’s emphatically not how valuations work. Extreme valuations are not equal to a near-term forecast about market direction. Rather, our investment discipline is to align our outlook with measurable, observable market conditions – including both valuations and market internals – and to shift our investment outlook as those conditions shift. No forecasts or scenarios are required.
Still, it’s impossible for us to examine current valuation extremes without also allowing for the S&P 500 to lose more than half of its value – even from here. That’s not so much a forecast as a “full cycle” estimate of the market loss that would be required to restore historically run-of-the-mill expected returns. It’s also worth noting that when Treasury bill yields have stood between 3-5%, as they do today, our most reliable valuation measures have stood at just half of their present levels, on average.
More immediate outcomes will be driven by the ebb and flow of investor psychology between speculation and risk-aversion, and we gauge that by the uniformity of market internals. Presently, both valuations and market internals remain unfavorable, which creates what I call a “trap door” situation.
Investors could certainly take the speculative bit back in their teeth, despite an overvalued market. That would be fine with us, as we’ve abandoned our belief that there is any well-defined “limit” to that willingness. Changes in Fed policy, reasonable or not, would also be fine with us, at least from the standpoint of our investment discipline. We’ll respond to conditions as they change, and take the evidence as it comes.
Two levers of the trap door
A few charts will help to illustrate our concerns about current market conditions. Below is our single most reliable valuation measure: the market capitalization of nonfinancial corporations as a ratio to gross value-added, including estimated foreign revenues. We gauge the reliability of our valuation measures based on their correlation with actual subsequent market returns across history. Other reliable measures (for example, Market Cap/GDP, S&P 500 price/revenue, and our Margin-Adjusted P/E) look quite similar. The advance to the January 2022 market peak took valuations beyond the extremes of 2000 and even 1929. Last year’s market decline merely skimmed the most speculative froth, bringing valuations to the same extreme we observed at the March 2000 bubble peak.
Emphatically, valuations don’t operate in a vacuum. It would have been impossible for valuations to reach speculative extremes like 1929, 2000, and 2022 without also continuing to advance persistently beyond lesser extremes. During the late-1990’s technology bubble, I scoured the historical data for factors that might help to distinguish an overvalued market that continues to advance from an overvalued market that drops like a rock. My answer was, and remains, investor psychology – specifically, whether investors are inclined toward speculation or risk aversion.
In 1998, I introduced our gauge of market internals – what I called “trend uniformity” at the time. It continues to be an essential element of our investment discipline. The specific signal extraction approach is one of the few things I keep proprietary, but I’m very open about the central concept. When investors are inclined to speculate, they tend to be indiscriminate about it, so the “uniformity” of market internals across thousands of stocks, industries, sectors, and security-types conveys information about that psychology.
In the face of zero interest rate policies, we had to abandon our bearish response to historically-reliable “limits” to speculation. In contrast, valuations and market internals continue to be essential to our investment discipline, and that emphasis has restored the strategic flexibility that we enjoyed across decades of complete market cycles. In my view, it would be profound mistake to take our difficulty with speculative “limits” as a reason to dismiss the “trap door” opened by the two levers of unfavorable valuations and unfavorable market internals.
The chart below presents the cumulative total return of the S&P 500 in periods where our measures of market internals have been favorable, accruing Treasury bill interest otherwise. The chart is historical, does not represent any investment portfolio, does not reflect valuations or other features of our investment approach, and is not an assurance of future outcomes. The flat portions in the chart below are periods when, like last year, market internals were persistently unfavorable, leading us to prefer T-bills or hedged equity to unhedged market risk. You’ll see the same tendency during the 2000-2002 and 2007-2009 collapses. We can’t rule out “whipsaws,” and we don’t expect internals to “catch” short-term market fluctuations. Still, in the nearly 25 years since I introduced our measure of market internals, I haven’t found a more useful way to gauge speculation versus risk-aversion.
Causes and conditions
By relentlessly depriving investors of risk-free return, the Federal Reserve has spawned an all-asset speculative bubble that we estimate will provide investors little but return-free risk.”
– John P. Hussman, Ph.D., Return-Free Risk, January 14, 2022
Over the past year, the S&P 500 has retreated only modestly from its January 2022 speculative peak, yet interest rates have normalized to a much greater extent. That, in my view, is probably the most dangerous aspect of the current market environment. We continue to observe valuations that were created only as the result of a decade of reckless zero-interest rate policy, yet zero-interest rate policy is no longer present.
As the Buddha taught, “All things appear and disappear because of the concurrence of causes and conditions. Nothing ever exists entirely alone; everything is in relation to everything else.” With interest rates now well above zero, the primary causes and conditions of the recent speculative bubble are no longer in place. The persistence of rich valuations here are, in my view, largely the result of psychological anchoring and hindsight that treats past prices as a standard of value. We saw the same thing during the 2000-2002 collapse, and it’s dangerous. I had friends who were wiped out, not by buying at the top, but by assuming that once prices had declined by 15%, or 20%, or in some cases 50% from the highs, the retreat somehow represented “value.”
I’ll say this again. Value is not measured by how far prices have declined, but by the relationship between prices and properly discounted cash flows. We presently estimate that the S&P 500 would have to drop to the 2800 level simply to establish prospective 10-year returns equal to those of 10-year Treasury bonds. Restoring a historically run-of-the-mill 5% expected return over-and-above Treasury bond yields would require a decline to the 1850 level. Restoring historically run-of-the-mill 10% expected long-term returns for the S&P 500 would require, by our estimates, a decline to the 1600 level.
Put simply, we estimate that the S&P 500 faces the same prospect of full-cycle loss and return-free risk as it did in 1929, 2000, and 2007. A massive recession is not required. Hyperinflation is not required. A housing collapse is not required. All that is required for a stock market collapse is for investors to demand historically run-of-the-mill prospective returns from stocks, rather than continuing to price stocks at speculative valuations that represented the equivalent of crying “uncle” in the face of zero interest rates.
The chart below shows our estimates of S&P 500 total returns in excess of 10-year Treasury yields, along with actual subsequent returns, in data since 1928. You will see lots of “equity risk premium” models on Wall Street. The problem is that, in general, we find that they don’t actually work well at all. That’s certainly true of Wall Street’s naïve favorite: forward operating yield – 10 year bond yield. As I noted last year, it’s also true of the Shiller-Black-Jirav “Excess Cape Yield.”
When you hear Wall Street analysts talking about the attractiveness of stocks versus bonds, it’s imperative to ask whether the model they’re using actually has any meaningful relationship to subsequent returns. It’s one of my great frustrations with this industry that the answer is typically “no.” Below is a measure that does pass that requirement. Unfortunately, we presently estimate that S&P 500 total returns are likely to lag the returns of Treasury bonds by -3.4% annually over the coming decade. Given that the 10-year Treasury bond yield is currently about 3.4%, that also implies that we estimate S&P 500 total returns to average about zero over the coming decade.
Fortunately or unfortunately, periods of negative estimated S&P 500 returns, relative to bonds, don’t tend to persist for long. In general, stocks tend to suffer severe losses over the next 30-36 months. The chart below illustrates this regularity. The horizontal axis shows the estimated S&P 500 total return in excess of 10-year Treasury yields. The vertical shows the value of an original $1 invested in the S&P 500, 30 months later. Notice that the points on the left side of the graph essentially collapse below 1.0. That’s the original investment getting wiped out.
The chart below illustrates the opening sentence of this month’s comment: “The problem with speculation is that there’s usually a gap between the underlying risk and the inevitable outcome.” The blue line shows the estimated loss in the S&P 500 that would be required to restore the greater of a) 10% expected S&P 500 nominal total returns; or b) a 2% expected risk-premium above Treasury bonds. The red shading shows the deepest actual subsequent S&P 500 loss over the following 3-year period. Notice that there’s often quite a bit of “white space” between the blue cups and the red ink that eventually fills them. That white space represents high risk with no apparent consequence; periods that enticed speculators to run across minefields and to push their luck.
Despite the profound risks that we believe are baked into the cake of valuations, I’ll say this again – at any point when our measures of internals suggest that investor psychology has shifted toward speculation, we’ll refrain from adopting or amplifying a bearish market outlook. Indeed, even at current valuations, a shift to uniformly favorable internals would encourage us to adopt a constructive market outlook more often than not (albeit with position limits and safety nets). We understand the valuation risks, but we also understand that there are certain periods when investors could not care less about valuation risks. Our job is to adhere to a value-conscious, historically-informed, risk-managed, full-cycle investment discipline, and we’ve adapted in ways that enable us to respond flexibly to market conditions as they change, without the risk of being “pinned” into any given market outlook.
On recession risk, inflation persistence, and embedded expectations
The National Bureau of Economic Research generally defines recessions as periods in which output, income, spending, and employment retreat in a way that combines depth, diffusion, and duration (though clear weakness in one feature can offset more moderate weakness in another). Currently, my view is that employment hasn’t deteriorated to the extent that would be consistent with NBER recession criteria – at least not yet.
– John P. Hussman, Ph.D., Are We There Yet?, July 2022
As the year begins, it’s common to see various outlooks circulated for 2023. My own view, detailed above, is that market valuations remain the most salient risk for investors, particularly given that interest rates are no longer at zero. It seems extremely optimistic for investors to expect smooth sailing, at valuations that still rival the 1929 and 2000 extremes, yet without the reckless zero-interest rate policies that enabled valuations to exceed 1929 and 2000 extremes in the first place. Still, as always, we’ll respond to market conditions as they change over time, and no forecasts are required.
My view on recession risk remains that employment hasn’t deteriorated to the extent that would be consistent with NBER recession criteria. Despite weakness in various measures of purchasing manager sentiment and credit stress, the employment components of our own Recession Warning Composites have also not yet shifted in a way that suggests an imminent recession.
Given current valuation extremes, I don’t believe that an official recession is necessary for stocks to experience severe losses. I do suspect that we’ll observe something that meets the definition of a recession even if the rate of unemployment rises beyond 4%, but my own expectations regarding the severity of a recession would require more deterioration than we see at present. In addition to employment measures, a steep widening in credit spreads coupled with a deterioration in consumer confidence and aggregate hours worked would contribute to more immediate recession concerns. For now, I don’t have terribly pointed expectations on the subject.
As for inflation, my impression is that investors have gotten far ahead of themselves by extrapolating modest improvement in the data. It may be that inflation improves progressively from here, but the problem is that investors have taken it for granted and embedded it into prices, which means that they now rely on that improvement. Any stall in progress on the inflation front, and particularly any upward surprise in core inflation even on the order of 0.2-0.4%, could be strikingly disruptive to both bonds and stocks.
For my part, I’ve always insisted on forming expectations by examining data. Frankly, there’s no better way than studying inflation data to prove to yourself that Wall Street, main street economists, the financial media, and the Federal Reserve are all spouting opinions completely off the tops of their heads, seemingly incapable of operating the most basic scatterplot.
See, the fact is that nearly everything people imagine is predictive of inflation has virtually no reliable relationship with inflation. That includes unemployment – as I’ve noted before, even the Phillips Curve is essentially a scarcity relationship between unemployment and real wage inflation. It has very little to do with general price inflation. Half of you just got mad at me. Don’t get mad. Come on, look at the data. Get into it. Get deep into it. You’re going to be so disappointed because everything you believe, everything you learned in Economics 101, is theoretical dogma.
Now, there are certainly useful perspectives on inflation – my own framework is to examine four drivers – the quantity of government liabilities (measurable), the demand for and confidence in government liabilities (psychological), the supply of goods and services along with slack capacity (measurable), and the demand for goods and services (psychological). As with the stock market, the psychological elements have a self-reflexive impact. Prices affect expectations, which affect prices. The upshot here is that the best predictor of inflation is, well, inflation, and lagged inflation. The next best correlates, but weaker, are negative economic shocks, and shocks to capacity and supply amid unsustainable government deficits.
So unless we get smacked by recession and credit strains, which aren’t really evident here, my impression is that inflation may be more persistent than investors seem to be banking on. That’s where investors are really getting themselves into danger. Based on historical relationships between interest rates, core inflation, nominal GDP growth, unemployment, and other factors, the lower bound for a “Fed pivot” and the typical lower bound for the 10-year Treasury bond yield are both in the area of 5.2% here. By pricing bonds and other assets in a way that assumes that inflation will come down rapidly and in a straight line, investors have put themselves in the position of relying on inflation to come down rapidly and in a straight line.
That’s not impossible. Can’t rule it out. But it’s not really how inflation tends to resolve. To the contrary, inflation shocks have historically had a strikingly long half-life.
The chart below illustrates this point. The vertical axis shows the slope coefficient relating the current inflation rate to the subsequent year-over-year rate, month by month, over the next 5 years.
Obviously, the highest correlation is in the first 12 months, declining as the overlap in the data declines. But the “half-life” of inflation is actually about 3-4 years, and the correlation between inflation at one point and inflation at another point only approaches zero after about 12 years.
The bottom line is simple. We don’t require forecasts, but investors should not ignore risks or insist on pushing their luck. The present combination of extreme valuations and unfavorable market action creates a “trap door” of downside risk for the financial markets. Likewise, the persistence of extreme valuations – in the absence of the causes and conditions that encouraged those extreme valuations – creates risk. The tendency of negative estimated risk-premiums to resolve into deep market drawdowns over the next 30-36 months creates risk. The reliance of investors on “forward earnings” multiples that embed record profit margins creates risk. The assumption that inflation will come down in a rapid and linear fashion, despite historical persistence of inflation, creates risk.
If our measures of market internals were to improve, we could at least infer that investors had shifted toward a speculative mindset, rather than one inclined toward risk-aversion. Presently, we observe a great deal of potential risk in an overvalued market where investors are also inclined to care about that risk.
Those conditions will change. Until then, we’re comfortably buckled up.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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The Hussman Strategic Allocation Fund invests primarily in common stocks, bonds, and cash equivalents (such as U.S. Treasury bills and shares of money market mutual funds, aligning its allocations to these asset classes based on prevailing valuations and estimated expected returns in these markets. The investment strategy adds emphasis on risk-management to adjust the Fund’s exposure in market conditions that suggest risk-aversion or speculation among market participants. The Fund may use options and futures on stock indices and Treasury bonds to adjust its relative investment exposures to the stock and bond markets, or to reduce the exposure of the Fund’s portfolio to the impact of general market fluctuations when market conditions are unfavorable in the view of the investment adviser.
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