April 4, 2016
In 1988, Yellowstone National Park went up in flames. In the worst catastrophe in the history of U.S. National Parks, nearly 800,000 acres of forest and surrounding areas were scarred by the uncontrollable blaze. The root cause of the inferno, as Mark Spitznagel recounts in his book The Dao of Capital, was fire suppression:
“The spread of fire-suppression mentality can be linked to the establishment of forest management in the United States, such that by the early 1900s forests became viewed as resources that needed to be protected - in other words, burning was no longer allowed. The danger of this approach became tragically apparent in Yellowstone, which was recognized by the late 1980s as being overdue for fire; yet smaller blazes were not allowed to burn because of what were perceived to be risks that were too high given the dry conditions. And so smaller fires were put out, but in the end could not be controlled and converged into the largest conflagration in the history of Yellowstone. Not only did the fire wipe out more than 30 times the acreage of any previously recorded fire, it also destroyed summer and winter grazing grounds for elk and bison herds, further altering the ecosystem. Because of fire suppression, the trees had no opportunity or reason to ever replace each other, and the forest thus grew feeble and prone to destruction... In 1995, the Federal Wildland Fire Management policy recognized wildfire as a crucial natural process and called for it to be reintroduced into the ecosystem... Central bankers, too, could learn a thing or two from their forestry brethren.”
In recent years, every market retreat has prompted central bankers to wriggle forth with fresh promises of suppressed interest rates and projectile money creation. I remain convinced that the great “policy error” of the Federal Reserve doesn’t lie in the future; in some mistake that might be avoided by good foresight or data-dependency. No, the great policy error of the Federal Reserve is long behind us; in the misguided insistence on sustaining yield-seeking speculation, overvalued financial markets, and dramatic expansion of low-grade covenant-lite debt. The third speculative bubble in 16 years is already well-developed, and the consequences are baked in the cake.
The danger of constant fire suppression is that it fosters the illusion that the entire forest is a controllable object, while actually weakening its capacity for resilience. Likewise, the danger of relentless Fed intervention is that it fosters the illusion that the financial markets are under the tight control of monetary policy, while encouraging malinvestment that amplifies the severity of the ultimate consequences. Nothing has been learned from 2000-2002 and 2007-2009, when even persistent and aggressive easing was incapable of holding back the inevitable collapse of malinvestment. The market plunges that completed those market cycles essentially represented the mass recognition by investors that they had badly miscalculated. Each successive bubble encourages them to forget that lesson. Now, we don’t doubt that central bankers will continue their recklessness. Rather, what investors should understand is that easy money actually only supports the market when investors are already inclined toward speculation (something I’ve previously demonstrated in both U.S. and Japanese data).
Until about mid-2014, Fed actions fueled persistent yield-seeking speculation, helping to drive the financial markets higher despite historically obscene valuations (on measures best correlated with actual subsequent 10-12 year market returns), strenuously overbought conditions, and lopsided bullish sentiment. Since mid-2014, however, the speculative impact of central bank jawboning has been increasingly short-lived. The main reason for this diminished carry-through is that investors actually shifted subtly toward greater risk-aversion more than 18 months ago; a shift that we inferred from deteriorating uniformity and broader dispersion of market internals across a broad range of individual stocks, industries, sectors, and security types, including debt securities of varying creditworthiness (when investors are inclined to speculate, they tend to be indiscriminate about it).
We still can’t imagine what central bankers believed that all of this intervention would achieve. Despite years of zero interest rates and massive expansion in the monetary base, the overall effect has been to move output, employment and industrial production hardly 1% from what would have been predicted purely on the basis of lagged non-monetary variables alone (this outcome can be verified by comparing constrained and unconstrained VARs). What possible marginal investment projects could take place at current interest rates that could not be productively initiated at rates a fraction of one percent higher? The answer is simple. Only 1) projects that are so hopelessly unpromising that even the slightest increase in the hurdle rate would make them unprofitable, and 2) speculative yield-seeking carry trades and foreign capital flows where the main consideration is interest itself, risking massive reversals in response to the slightest change in conditions.
Market collapses don’t come out of the blue. Across history, they have emerged primarily from conditions where rich valuation has been joined by deterioration in market internals. Though Spitznagel focuses primarily on the valuation side of market conditions, he makes a similar point - extremely negative market outcomes don’t emerge randomly:
“Truly, the real black swan problem of stock market busts is not about a remote event that is considered unforeseeable; rather it is about a foreseeable event that is considered remote. The vast majority of market participants fail to expect what should be, in reality, perfectly expected events.”
From a full-cycle perspective, we continue to expect that the completion of the present market cycle will likely involve a retreat in the S&P 500 Index on the order of 40-55%. From a longer-term perspective, as I emphasized with nearly a century of evidence last week, we expect nominal total market returns to average 0-2% over the coming 10-12 year horizon. Emphatically, these would be only run-of-the-mill outcomes, in the sense that they would bring historically reliable valuation measures to the same norms that they have approached or breached during the completion of every market cycle across history, including recent market cycles, as well as cycles prior to the 1960’s when interest rates were regularly comparable to present levels.
With respect to the very near-term, we’ve maintained a neutral, not hard-negative market outlook in recent weeks. That’s largely due to improvement in various trend-following measures. Though market conditions are strenuously overbought and our most reliable market return/risk measures remain unfavorable, the return/risk profile we currently identify has historically been associated with: a) the tendency for the market to enjoy modest, incremental gains more frequently than not, b) coupled with larger but less frequent vertical losses that ultimately wipe out those gains in one fell swoop. If you picture a bell curve of probable market returns, that’s another way of saying that the expected return distribution has negative skew with a fat tail. It’s an environment where things seem very pleasant and stable until they suddenly aren’t.
Now, we can’t rule out that speculators could get the bit back in their teeth (which we would again infer from uniformity and dispersion across broad market internals), which might support a stance that could be described as “constructive with a safety-net.” Still, I can’t envision any upside scenario in which it would be appropriate to operate without a nearby safety net. In no case would near-term market strength improve the full-cycle or long-term prospects of the market, both which remain dismally baked-in-the-cake as a result of obscene valuations. Presently, we would expect to shift back to a hard-negative market outlook on a break below about 1975 on the S&P 500.
Overall, my view remains that the market is in the late-stage of a broad, rounded top-formation extending back to 2014. We estimate that “tail risk” - in particular, the risk of a compressed 20-25% market plunge - is growing rather than receding. To a large extent, the threshold risk I emphasized in February is still relevant. A market break below about the 1820 level on the S&P 500 - and one should not imagine that such a retreat could not unfold quite rapidly - would violate such a well-recognized “support” level that concerted attempts to exit would likely follow, with little buying interest on the other side of that trade until about the mid-1500’s (which represents an equally well-recognized “role-reversal” support level corresponding to the 2000 and 2007 market peaks). It’s important to recognize that once an extended period of overvalued speculation has been joined by deteriorating market internals and waning momentum (combining to create a broad top formation), an initial market retreat of about 14%, followed by a rebound in excess of 10%, has typically made a market crash more likely than if that rebound was weak. The 1929 and 1987 crashes were preceded by fairly subdued rebounds during the associated top formations, while the 2000 and 2007 peaks featured more robust ones. In the end, those subtleties didn’t matter much.
To summarize, our near-term market outlook remains neutral, though it does feature meaningful tail risk. We don’t exclude the outside possibility of a shift back toward yield-seeking speculation (which we would infer from the behavior of market internals), but expect that even that environment would demand a safety net against fresh deterioration. In any event, it will remain critical to defend against downside risk that is already irrevocably baked in the cake. At best, improved market internals would only change the appropriate form of that defense. Regardless of near-term prospects, we expect the S&P 500 to lose 40-55% of its value over the completion of the present market cycle, with 0-2% nominal total returns over a 10-12 year horizon, both which would represent entirely run-of-the-mill outcomes from current valuations. As always, we’ll respond to new evidence as it emerges.
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. Please see periodic remarks on the Fund Notes and Commentary page for discussion relating specifically to the Hussman Funds and the investment positions of the Funds.
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