November 7, 2016
High Risk and Low Conviction
Since everyone is probably drowning in pre-election opinions, I decided that a brief comment focused on key considerations might be welcome. While the extent of the market retreat from the August peak has been quite shallow, a variety of short-term technical indicators appear “oversold” because the recent decline has breached the narrow trading range that has prevailed in recent months. From a cyclical perspective, however, the most historically reliable market valuation measures remain so extreme that a 40-55% loss in the S&P 500 would be only historically run-of-the-mill completion of this market cycle.
Short-term oversold conditions offer a sense of potential knee-jerk dip-buying behavior, but the conviction of that behavior is often fairly weak and short-lived. Meanwhile, extreme valuations imply the likelihood of steep market losses over the complete cycle, and also for poor S&P 500 total returns on a 10-12 year horizon, but valuations often have little effect on near-term market behavior. Instead, the behavior of the market over shorter segments of the cycle is driven not only by valuations but also by the preference of investors toward risk-seeking or risk-aversion. That’s really the aspect of present conditions that now gives extreme valuations their bite. Investor risk-preferences, as conveyed by the uniformity or divergence of market internals, are the hinge between overvaluation that persists and overvaluation that devolves into air pockets, free-falls, and crashes. Given that deteriorating market internals (particularly since mid-September) have continued to suggest increasing risk-aversion among investors, it’s not at all clear that short-term “oversold” measures will provide much support. For our part, we continue to classify market conditions among the most hostile market expected return/risk profiles we’ve identified across history. Regardless of the potential for a near-term “relief rally,” our defensive market view is likely to shift only as the combination of valuations and market action improve.
Last week, the S&P 500 retreated to its 200-day moving average. On one hand, this is a natural point for dip-buyers to offer support. On the other hand, a breach of that support would be an equally natural point that could trigger coordinated exit attempts by trend-followers. At the August peak (see Looking Ahead to a Bullish Outlook, and What Will Define It), I noted that the position of the S&P 500 relative to its 200-day moving average is not what defines favorable market action or our overall market return/risk classification. Indeed, once our estimated market return/risk profile is strictly negative (as it is at present), the negative implications for the S&P 500 aren’t affected by the position of the market relative to that average, except that the market tends to experience higher volatility once the market breaks that average. I observed, “The main reason to track the 200-day average here is because it is a widely-referenced trend-following pivot. A decline much more than 2% below that average could provoke coordinated exit attempts by trend-followers, at valuations nowhere near the point where value-conscious investors would be eager to absorb those shares.”Put simply, we continue to classify the expected market return/risk profile as hard-negative. Valuations remain offensive, and market action continues to suggest increasing risk-aversion and an exhaustion of yield-seeking speculation. Historically, the most spectacular market losses typically emerge when overvalued, overbought, overbullish extremes are joined by increasing risk-aversion, as evidenced by breakdowns and dispersion across market internals. In contrast, the strongest market return/risk profiles we identify typically emerge when a material retreat in valuations is joined by an early improvement in market action. Everything else, including politics and monetary policy, will filter through those observables, and our outlook will shift as the observable evidence changes.
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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