After some gut-wrenching volatility in August, global markets have settled down in the past couple of weeks.
They have also rebounded nicely off the August lows.
As markets have calmed, the debate about whether we’re in the early stages of a full-on crash has quieted.
But don’t be fooled.
This is still an open question.
At times like these, it’s helpful to get a historical perspective.
And what you find when you do that is that no one who is concerned about a crash should take comfort in the market’s recent stabilisation.
Because market crashes take time.
The market’s recovery from the August lows might, in fact, be a “buying opportunity” that is the beginning of another surge to record highs.
But it also might be one of those bear-market rallies that have punctuated nearly every major market collapse in history.
The charts below, from portfolio manager John Hussman of the Hussman Funds,* illustrate this.
The charts show how the last three major market crashes were preceded by initial drops of 10% to 15% followed by sharp rebounds like the one we’re experiencing right now. These rallies seemed comforting and encouraging at the time. But then, just as many traders had decided it was safe to get back in the water, the real crash began.
First, 1987. In 1987, stocks peaked in August and then sold off sharply. Then they began a rally that, by early October, had recovered almost all of the losses. The top chart shows this rally, which was presumably quite comforting to traders at the time. The bottom chart shows what happened next.
Then 2000. As I and many other veterans of the era remember well, the “Great Bubble” of the 1990s peaked in the spring of 2000 — and then stocks sold off sharply. This initial sell-off, however, was followed by a reassuring summer recovery. By fall, a full 6 months after the initial sell-off, we had regained almost all of the lost ground, and boatloads of smart people were congratulating themselves for “buying the dip” and “climbing the wall of worry.”
Then came the disastrous 18 months that followed.
And 2007. As most of us remember, the years leading up to the global financial crisis were very good ones for the market. Stocks sold off sharply in July, but then recovered and surged to new highs. Then they sold off even more sharply in October. By March of 2008, however, with everyone being assured that sub-prime debt problems were “contained,” stocks began to rally again. By June, they had made up most of the lost ground. Then they fell off a cliff.
In short, as Mr. Hussman explains in a note, the recent stock market action actually looks similar to the action that has preceded the three most recent crashes:
[M]arket crashes “have tended to unfold after the market has already lost 10-14% and the recovery from that low fails.” Prior pre-crash bounces have generally been in the 6-7% range, which is what we observed last week …
Meanwhile, even with stocks down about 5% to 10% from their record highs, valuations remain extreme.
This chart, also from Hussman, shows a measure of valuation that, in Hussman’s analysis, has shown the greatest correlation with future long-term price performance. The blue line shows the annual return that the measure predicts stocks will provide over the following 10 years, which is currently about 0%. The red line shows the actual performance of stocks over the following 10 years. (The red line ends 10 years ago.)
How big a pullback could we see if the recent dip is only the beginning of a crash? This and other valuation analyses suggest that “fair value” for stocks is only a little more than half of today’s prices. So, as Hussman observes, a pullback of 40% to 55% from the highs would not be a worst-case scenario. Rather, it would be a garden-variety regression to the mean:
We fully expect a 40-55% market loss over the completion of the present market cycle. Such a loss would only bring valuations to levels that have been historically run-of-the-mill.
So don’t feel too good about the recent market action!
* Yes, I know, John Hussman’s performance has been poor in recent years. So why am I citing his analysis? Because I find it far more rigorous and persuasive than the vast majority of the bullish analysis out there, most of which can be summarized as vague reassurances that “it’s different this time.” Hussman has explained clearly why his recent performance has been lousy (because he positioned his portfolio to survive additional downside during the financial crisis and has never caught up). And as everyone in the investment business should know, recent past performance is distinctly not indicative of future results.
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