- By multiple measures, US equity valuations are close to the highest on record.
- Investor and former professor John Hussman doesn’t think this is a sustainable situation, and forecasts that stocks will see negative returns over a 12-year period.
- Hussman’s perma-bearish views have seen mixed success in the past, and a good number of Wall Street strategists are bullish on US stocks through 2018.
As the equity bull market has climbed into rarefied air, investors have continuously come up with new ways to rationalize the rally.
Right now, they like to cite earnings growth, which has expanded for several quarters after a prolonged rough patch. They also frequently mention interest rates that, despite hawkish signals from central banks, have remained low, supplying the market with a seemingly endless supply of cheap money.
On the other side of the spectrum, John Hussman, the president of the Hussman Investment Trust and a former economics professor, thinks that the investment community is unwisely ignoring the most stretched valuations in history on the heels of a nearly 300% bull market run. Ever the outspoken bear, Hussman says investors are being wilfully ignorant, which has stocks at risk of a drop that could reach 63% and send the market spiraling into a full decade of negative returns.
It wouldn’t be the first time in history this has happened. But Hussman thinks this crash will be different, because the reasons for market instability are “purely psychological” this time around, according to a recent blog post.
‘US equity market valuations are at the most offensive levels in history’
At the root of Hussman’s pessimistic market view are stock valuations that look historically stretched by a handful of measures. According to his preferred valuation metric — the ratio of non-financial market cap to corporate gross value-added (Market Cap/GVA) — stocks are more expensive than they were in 1929 and 2000, periods that immediately preceded major market selloffs.
“US equity market valuations at the most offensive levels in history,” he wrote in his November monthly note. “We expect that more extreme valuations will only be met by more severe losses.”
Those losses won’t just include the 63% plunge referenced above — it will also be accompanied by a longer 10 to 12 year period over which the S&P 500 will fall, says Hussman. He cites the chart below, which shows how closely 12-year expected returns for the benchmark have historically tracked Market Cap/GVA, which is shown in inverted fashion. Note that the expected trajectory for Market Cap/GVA shows the S&P 500 veering into negative territory.
The psychology behind the market’s willingness to accept lofty stock valuations stems from the flawed rationale that prices are justified by low interest rates, says Hussman. To him, the US economy is growing too slowly for this to be true, and that any belief to the contrary gives people false confidence.
Investor minds are also being warped by their lengthy and ongoing experience with rock-bottom interest rates, according to Hussman. This has fed the belief that only risky assets can generate desirable returns, and that they should be purchased regardless of price.
“Unfortunately, valuation extremes and speculative moods are always impermanent,” he wrote. “It’s that failure to distinguish temporary returns from durable ones that will likely end with most investors surrendering every bit of return they have enjoyed since 2000.”
The life of a perma-bear
It must be noted, however, that Hussman has been sounding the alarm on a major stock market selloff for years now. Throughout the second half of 2014, he issued regular warnings about a crash, even going as far as to say stocks were crashing in October 2014. The S&P 500 has rallied another 30% since then.
Hussman’s view also stands in stark contrast to many experts across Wall Street — most notably the equity strategists responsible for each firm’s S&P 500 forecasts. They forecast that the benchmark will be little changed from current levels into year-end, according to data compiled by Bloomberg.
Looking ahead to 2018, UBS sees the S&P 500 climbing as much as 9% over the course of the year. Meanwhile, Goldman Sachs thinks US stocks will be kept afloat by speculation and progress around tax reform.
Still, Hussman isn’t alone in the perma-bear camp. He has company in the form of Societe Generale investment strategist Albert Edwards, who also sees a stock market crash lurking around the corner.
In a recent note to clients, Edwards identified the self-described “nightmare scenario” for what could cause a massive stock blowout. He said that it could ultimately involve the Federal Reserve raising rates too slowly, combined with a sharp uptick in wage inflation.
What’s interesting about the bearish arguments presented by both Edwards and Hussman is that there’s no firm timetable attached to either prediction. In fact, Hussman actually acknowledges that he’s neutral in the near term, because while conditions are ripe for a crash, people are going to keep buying until the bitter end.
“It’s enough to be neutral here,” said Hussman. “With that, further speculation in a wickedly overextended market may not help us much, but it shouldn’t hurt us much either. In the meantime, my honest opinion is that Wall Street has gone completely mad.”