Hussman Market Comment

It’s enormously tempting to imagine, at bubble highs, that glorious backward-looking returns, far greater than those previously implied by valuations, demonstrate that historical standards of value are outdated and obsolete. In 1934, Benjamin Graham and David Dodd described the mood surrounding the 1929 market peak, observing that investors had abandoned their attention to valuations because 'the records of the past were proving an undependable guide to investment.' For the moment, neither valuations nor arithmetic matter to investors. As Galbraith observed, 'As long as they are in, they have a strong pecuniary commitment to belief in the unique personal intelligence that tells them that there will be yet more.'

On Friday December 6th, the U.S. stock market pushed to the most extreme level of valuation in U.S. history, based on the measures that we find best-correlated with subsequent S&P 500 total returns, as well as the depth of subsequent losses over the completion of market cycles across a century of data. That’s not a forecast. Rather, it’s a statement about current, measurable, observable market conditions.

Change is the sum of fundamental trends, the gradual elimination of accumulated extremes, and the random arrival of new shocks. This is true for nearly every process, including economic growth and stock market returns.

One of most dangerous habits of a speculative crowd is the tendency to use unconditional averages and unconditional probabilities regardless of how extreme market conditions have become. This is like stepping into a house with two rooms, one with the temperature at 0 degrees and one at 140 degrees, and expecting a temperature of 70 either way.

It's the wrong question to ask, "How can we somehow force internals to look like trend-following measures that aren't as reliable across history?" Happily, abandoning that question frees us to ask a better question. Once one accepts that internals are, in fact, behaving as intended, the question becomes: "How can we benefit during bearish conditions when valuations and internals validly hold us to a defensive outlook, yet obvious but less reliable trend-following measures remain favorable?" As John Dewey wrote, a problem well-stated is half-solved.

The key takeaway is that attending directly to market internals is actually more effective than attending to monetary easing or tightening. Still, given that we can expect a pivot toward lower rates in the near future, how much do valuations tend to increase, on average, in the 3, 6, 12, and 24 months following a Fed pivot? The answer is simple. They don’t.

There’s a very rare set of market conditions extreme enough to deserve a ‘warning.’ As Madge said in the old Palmolive dish soap commercials, ‘you’re soaking in it.’

I may as well just say it. Based on the present combination of extreme valuations, unfavorable and deteriorating market internals, and a rare preponderance of warning syndromes in weekly and now daily data, my impression is that the speculative market advance since 2009 ended last week. Barring a wholesale shift in the quality of market internals, which are quickly going the wrong way, any further highs from these levels are likely to be minimal. In contrast, current valuation extremes imply potential downside risk for the S&P 500 on the order of 50-70% over the completion of this cycle.

Statistically, the current set of market conditions looks more “like” a major bull market peak than any point in the past 75 years, and I suspect, any point other than the 1929 peak. As Jeremy Grantham recently observed, "This is where you start bear markets from."