In his weekly letter, John Hussman cites a confluence of historical factors — a little bit Hinderburg-Omen-eseque, if you will — that signal that it’s a horrible time to invest.
In recent weeks, the U.S. stock market has been characterised by an overvalued, overbought, overbullish, rising-yields syndrome that has historically been hostile to stocks. Last week, the situation became much more pointed. Past instances have been associated with such uniformly negative outcomes that the current situation has to be accompanied by the word “warning.”
The following set of conditions is one way to capture the basic “overvalued, overbought, overbullish, rising-yields” syndrome:
1) S&P 500 more than 8% above its 52 week (exponential) average
2) S&P 500 more than 50% above its 4-year low
3) Shiller P/E greater than 18
4) 10-year Treasury yield higher than 6 months earlier
5) Advisory bullishness > 47%, with bearishness < 27% (Investor’s Intelligence)
[These are observationally equivalent to criteria I noted in the July 16, 2007 comment, A Who’s Who of Awful Times to Invest. The Shiller P/E is used in place of the price/peak earnings ratio (as the latter can be corrupted when prior peak earnings reflect unusually elevated profit margins). Also, it’s sufficient for the market to have advanced substantially from its 4-year low, regardless of whether that advance represents a 4-year high. I’ve added elevated bullish sentiment with a 20 point spread to capture the “overbullish” part of the syndrome, which doesn’t change the set of warnings, but narrows the number of weeks at each peak to the most extreme observations].
The historical instances corresponding to these conditions are as follows:
December 1972 – January 1973 (followed by a 48% collapse over the next 21 months)
August – September 1987 (followed by a 34% plunge over the following 3 months)
July 1998 (followed abruptly by an 18% loss over the following 3 months)
July 1999 (followed by a 12% market loss over the next 3 months)
January 2000 (followed by a spike 10% loss over the next 6 weeks)
March 2000 (followed by a spike loss of 12% over 3 weeks, and a 49% loss into 2002)
July 2007 (followed by a 57% market plunge over the following 21 months)
January 2010 (followed by a 7% “air pocket” loss over the next 4 weeks)
April 2010 (followed by a 17% market loss over the following 3 months)
Since Investor’s Intelligence data is not available prior to the mid-1960’s, we get a few additional observations if we drop the “overbullish” criteria in prior years. These include December 1961 (followed by a 28% market loss over the following 6 months) and a few quick market plunges in the mid-1950’s. I’ve excluded these in the list above because we don’t have associated sentiment readings.
It’s not pleasant to adhere to our discipline here, but I believe that it is essential to do so, because conditions like these are often where it matters most, despite the discomfort. We’ve lost several per cent in the Growth Fund in an advancing market, reflecting a tendency of investors to abandon stable investments in preference for the “risk trade” in highly cyclical stocks, as well as option time decay in an environment where defence is seen as unnecessary. The market’s recent embrace of the “risk trade” can be traced to the apparent endorsement of risk-taking by the Fed. Still, it’s wise to remember that while Fed Chairmen have proven to be apt encouragers of bubbles over the short term, the “Greenspan put” certainly didn’t avoid the 2000-2002 mauling, nor did the “Bernanke put” avoid the even deeper 2007-2009 plunge. The only put options that investors can rely on here are the contractual kind.
It’s fair to criticise my inclusion of other post-credit crisis data in my evaluation of market conditions since 2009. While I didn’t believe it was proper to use strictly post-war data when conditions were clearly “out of sample,” it turns out that investors have approached the market as a “typical” post-war cycle, and been willing to overlook whatever underlying strains persist in the financial system. I suspect this is because FASB does not require mark-to-market reporting on the actual value of assets held by financial institutions, and because nobody cared when the Federal Reserve illegally acted outside of Section 14(b) of the Federal Reserve Act by purchasing $1.5 trillion of GSE debt that is a) not guaranteed as to principal and interest by the U.S. government, b) is not foreign government debt, and c) is not U.S. government agency debt. On this, note the distinction made in 2001 by William Poole, the head of the Federal Reserve Bank of St. Louis, in a paper entitled The Role of Government in US Capital Markets. Poole distinguishes GSEs such as Fannie Mae and Freddie Mac from “Ginnie Mae, the Veterans Administration, and the Federal Housing Authority, which are not GSEs but instead are agencies of the federal government carrying the full faith and credit of the government.” In another paper, GSE Risks, Poole observes about Fannie and Freddie (F-F) that “although many investors assume that F-F obligations are effectively guaranteed by the U.S. government, the fact is that the guarantee is implicit only.” I continue to believe that Fed purchases of GSE debt were in violation of the Federal Reserve Act, as were the Maiden Lane transactions. In any event, however, the integrity of the U.S. financial system is an open topic for debate, and there is not clear data by which to resolve the matter one way or another. My insistence on expanding the data set to other post-crisis periods has clearly not been helpful since 2009, and at least to this point, my concerns have been misplaced.
Still, it’s important to recognise that our defensiveness here is unrelated to issues regarding credit or economic concerns. However one judges the inclusion of post-credit crisis data in our analysis (which kept us more defensive than was necessary, in hindsight, particularly during 2009 and early 2010), the fact is even discarding that data, our best post-war measures have been defensive since the April high, and dramatically so over the past several weeks.
Our concern about overvalued, overbought, overbullish, rising-yields conditions should be evaluated on the basis of the data regarding that syndrome of conditions, and this data is readily available. As noted above, the evidence is uniformly hostile. Importantly, the instances listed did not require a backdrop of unfavorable economic conditions. The average Purchasing Managers Index at the time of these market peaks was 58. The PMI was relatively stable, on average, over the following 3 months. The rate of new unemployment claims was typically near its 5-year average. By definition, stock prices were in an uptrend at the time. Overvalued, overbought, overbullish, rising-yield conditions are unfavorable in and of themselves. The present instance may turn out differently, but that expectation would be a clear outlier.
We certainly are aware of trend-following models that are positive here, but these things are testable, and when we do so, we find that they have performed less well over the long-term, and with much larger drawdowns, than our Market Climate approach (if that wasn’t the case, we would be using them instead). As I noted in recent weeks, we’ve introduced robust modifications that broaden the number of Climates we define, and will allow us to take moderate, transitory exposure to market fluctuations much more frequently. So despite our present defensiveness, we expect to have more sensitivity to short and intermediate-term fluctuations as we move forward. Clearing the overbought and overbullish components of the present environment, without a significant breakdown in overall market internals, would be the quickest way to prompt a more constructive stance, even in what we view as an overvalued market. All of that said, we are hard defensive here.
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