Extreme Conditions and Typical Outcomes

John P. Hussman, Ph.D.
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As of Friday, the S&P 500 has advanced to a point where it is either within 0.1% or fully through its top Bollinger band on virtually every horizon, including daily, weekly and monthly bands. We can define an "overvalued, overbought, overbullish, rising-yields syndrome" a number of ways. The more general the criteria, the better you capture historical instances that preceded abrupt market weakness, but the more you also encounter "false positives." Still, as long as the criteria capture the basic syndrome, we find that the average return/risk profile for subsequent market performance is negative, almost regardless of the subset of history you inspect.

It's clear that present conditions are among the most extreme in history. In fact, to capture instances other than today, 1987 and 2007, we have to broaden the criteria. The following are sufficient for purposes of discussion:

1) Overvalued: Shiller P/E over 18 (presently, the multiple is over 24)

2) Overbought: S&P 500 within 1% of its upper Bollinger band on a daily, weekly and monthly resolution (20 periods, upper band 2 standard deviations above the moving average), and S&P 500 at least 20% above its 52-week low.

3) Overbullish: Investors Intelligence bullish sentiment at least 45% and bearish sentiment less than 25% (presently, we have 54.3% bulls and 18.5% bears).

4) Rising yields: Yields on the 10-year Treasury and the Dow 30 Corporate Bond Average above their levels of 6 months earlier.

I should note that while present conditions easily fit into the foregoing criteria, we generally use a somewhat less restrictive criteria to define an "overvalued, overbought, overbullish, rising-yields syndrome in practice, in order to capture a larger number of important but less extreme periods of risk. The foregoing set of conditions isn't observed often, but the historical instances satisfying these criteria in post-war data are instructive. Here an exhaustive list of them:

August 1972, November-December 1972: The S&P 500 quickly retreated about 5% from its August peak, then advanced again into to its bull market peak near year-end (about 6% above the August peak). The Dow then toppled -12.3% over the next 50 trading days, and collapsed to half its value over the following 22 months.

August 1987: The market advanced about 6% from its initial signal into late August. The S&P 500 then lost a third of its value within 8 weeks.

June 1997: The only mixed outcome, during the strongest segment of the late 1990's tech bubble. The S&P 500 advanced another 10% over the following 8 weeks, surrendered 4%, followed with a strong advance for several months, surrendered it during the 1998 Asian crisis, and then reasserted the bubble advance. Over a 5-year period, the overvaluation ultimately took its toll, as the the S&P 500 would eventually trade 10% below its June 1997 level by the end of the 2000-2002 bear market. Still, the emergence of the internet, booming capital spending, strong economic growth and job creation, rapidly falling inflation, and dot-com enthusiasm evidently combined to overwhelm the negative short- and intermediate-term implications of this signal.

July 1999: The S&P 500 advanced by 3% over the next two weeks, then declined by about 12% through mid-October, and after a recovery to the March 2000 bull market high, the S&P 500 fell far below its July 1999 level by 2002.

March 2000: The peak of the bubble - the S&P 500 lost 11% over the following three weeks, recovered much of that initial loss by September, and then lost half its value by October 2002.

May/June 2007, July 2007: The S&P 500 gained 1% from the late-May/early-June signal to the July signal, then lost about 10% through August 2007, recovered to a marginal new high of 1565.15 by October (about 1% beyond the August peak), and then lost well over half of its value into the March 2009 low.

February 2011, April 2011: A cluster of signals in the 2-week period between February 8-22 immediately followed by a decline of about 7% over the next 3 weeks. As of Friday, the market has recovered to a marginal new high about 1.5% above the February peak.

So not including the cluster of signals we've observed in recent months, we've seen 6 clusters of instances in post-war data (we're taking the 1997, 1999 and 2000 cases as separate events since they were more than a few months apart). Four of them closely preceded the four worst market losses in post-war data, one was quickly followed by a 12% market decline, and one was a false signal over the short- and intermediate-term, yet the S&P 500 was still trading at a lower level 5 years later. The red bars indicate instances of this syndrome since 1970, plotted over the S&P 500 (log-scale).

Examining this set of instances, it's clear that overvalued, overbought, overbullish, rising-yields syndromes as extreme as we observe today are even more important for their extended implications than they are for market prospects over say, 3-6 months. Though there is a tendency toward abrupt market plunges, the initial market losses in 1972 and 2007 were recovered over a period of several months before second signal emerged, followed by a major market decline. Despite the variability in short-term outcomes, and even the tendency for the market to advance by several percent after the syndrome emerges, the overall implications are clearly negative on the basis of average return/risk outcomes.

We know that weak prospects for the market over a horizon of years does not necessarily translate into weak market prospects over a horizon of months. The ensemble methods we introduced last year have a greater tendency to accept moderate, if periodic, investment exposures - even in quite overvalued markets. But even with our present methods, the odds for the market are now quite bad, and I have no intent of accepting needless risk in historically hostile market conditions in order to prove our willingness to accept greater market exposure more generally.

Even here, we would be willing to establish a moderate, if transitory, exposure to market fluctuations (though with a line of index put defense against extended weakness in any event) even on modest events that "clear" the present syndrome. For example, provided that a market decline isn't severe enough to damage broad market internals (breadth, leadership, industry uniformity, price/volume behavior, credit spreads, and so forth), it would be enough for sentiment to retreat to perhaps 45% bulls, or for 10-year Treasury yields decline below their level of 6 months ago. At this point, we would probably require a market decline of more than 6% to clear the "overbought" component, but there are other combinations that could be sufficient to shift the short- to intermediate-term return/risk profile to a more favorable condition. In any event, however, three things should be clear: 1) we have significant concerns about longer-term market outcomes, 2) market conditions don't not rule out the possibility of further gains or extended sideways movement over the short- and intermediate-term, but the odds are poor, and 3) we are willing to establish moderate, transitory exposure, albeit with a line of index put option protection in any event, if we can clear some component of the present syndrome, but the evidence is strongly against more aggressive positions.

Notes on a challenging market cycle

On nearly every economic and financial measure, the cycle from 2007 to the present has undoubtedly been a striking outlier from the standpoint of history. Likewise, it has been an outlier for us - particularly in Strategic Growth. It is almost unfathomable that we could have accurately anticipated the financial crisis and associated market plunge in 2007-2008, recognized in 2009 that stocks were undervalued and priced to achieve 10-year returns above 10% annually, and yet that we failed to gain a substantial advantage over a buy-and-hold approach other than substantially reduced volatility and a far smaller maximum loss. If this outcome was "typical" behavior for our investment approach, I certainly would not have virtually all of my assets in the Hussman Funds, with the largest allocation to Strategic Growth. So it is important to recognize why the recent cycle has been unique. Though this period has created difficult challenges, I am convinced that the "ensemble methods" that we have developed in response make us even better equipped to achieve strong long-term returns at controlled risk than when we launched the Funds more than a decade ago.

I've never been much for "gathering assets" or whatever other investment companies do with all their advertising efforts and marketing staff. We focus on pursuing a long-term investment discipline for our long-term shareholders, and not much else. Aside from these comments, which are intended as a conversation with our shareholders (and my opportunity to continue teaching outside of academia), our only marketing effort is what I frequently call our "anti-marketing" plea: don't invest in the Hussman Funds if you wish to closely track market fluctuations or have an investment horizon shorter than a complete bull-bear cycle. My interest in these weekly comments is for our long-term shareholders to understand our approach, to see the evidence that I am observing, to stay informed on what we are doing and why - and particularly in the most recent cycle, to discuss our challenges and how we have resolved them.

Given the extraordinary fiscal and monetary indulgence that has been heaped upon the economy in recent years, it is tempting to believe that the world has changed in ways that make structured, historical, value-based analysis inappropriate. But in my view, this gives far too much long-term credit to short-term phenomena. It's certainly true that we ought to adapt to the possibility that valuation "norms" will be higher (and long-term return expectations will be lower) in the face of persistent policy efforts to elevate asset prices and foment bubbles. Still, our estimates of expected market returns have remained very accurate even in the most recent decade, so the lesson is not that valuations don't matter, or that 2+2 no longer equals 4 (our long-term return estimates are essentially basic algebra), but rather that policy makers may engender higher valuations and lower long-term return prospects more frequently in the years ahead than they have in the past.

It's worth repeating that as we entered 2008, our essential "machinery" for estimating the profile of risk and return in the market was based on post-war U.S. data. Encompassing nearly 70 years of historical evidence, I had believed that this was sufficient. While I anticipated significant credit strains, I was profoundly wrong in expecting that policy-makers would do the right thing in response, which would have required the write-down of perhaps $2 trillion in bad assets. If you figure the U.S. stock market is about $14 trillion in market capitalization and an average bear market wipes out nearly a third of market cap, $2 trillion in write-downs would have been "cheap". But that $2 trillion was largely bank capital, and nobody had the will to swiftly restructure banks or allow bank bondholders to take losses. So our policy makers instead opted for a course of action that triggered panic, froze credit, created economic uncertainty, prompted millions of job losses, generated a massive inventory of delinquent and unrestructured mortgage debt, and fostered what I continue to view as a "zombie" banking system where dead assets remain on the balance sheets as if they are still alive. The required losses and restructuring remain incomplete, in my view.

As the crisis unfolded, it became clear that conditions were "out of sample" from a post-war perspective, and we needed to contemplate Depression-era data in estimating the likely return/risk profile for stocks. But even recognizing the need to integrate this data into our modeling, there was no straightforward way to do it effectively in a single model (something I repeatedly referred to as the "two data sets problem").

From the subsequent work we've done on ensemble modeling, we know where we might have done things differently during the most recent cycle. In hindsight, we could have accepted even less exposure in late-2008 than we did (the oversold conditions and breadth reversals at the time were not accompanied by other forms of confirmation in 2008 or in the Depression, as they normally were in post-war data). Conversely, we could have accepted greater exposure in 2009 and early 2010 (though the stock market lost two-thirds of its value in the Depression even after prospective 10-year returns had reached 10%, the Depression era featured continued upward pressure on credit spreads, and a variety of other risk factors that were not evident as 2009 proceeded).

In short, I am convinced that a combination of observable data can reasonably account for the major losses in the post-war period, the Depression-era, and other periods of credit crisis, while also accounting for much of the total returns observed over history, including 2009 and early 2010. As I've noted before, the practical benefit of the ensemble approach is that it makes us less reliant on any single model or subset of historical data, and allows us to distinguish "risk" from "uncertainty" (see our Semi-Annual Report for more extended comments on this distinction). The most observable effect of the approach is likely to be a tendency of the Funds to accept at least moderate exposures to market fluctuations more frequently, even in conditions that we might view as overvalued from a longer-term perspective. Notably, the ensembles also place somewhat greater emphasis on "trend-following" elements than we previously incorporated, but still refuse the sort of blind trend-following (such as ignoring overvalued, overbought, overbullish, rising-yield syndromes) that would historically degrade performance and regularly invite losses.

All of that said, our defensiveness since April 2010 remains consistent with evidence from both post-war and Depression era data. I emphatically believe that quantitative easing is a reckless and misguided policy, and should not be relied on as a durable basis for speculation. It is also clear that the syndrome of overvalued, overbought, overbullish, rising-yields conditions typically leads to tears, on average, regardless of the subset of historical data one chooses to analyze. Despite what, in hindsight, were missed opportunities to accept market risk in 2009 and early 2010, now is not then. Conditions are far different, and far more hostile. Though the difficult lessons of the recent cycle have been the source of frustration, those lessons are also the basis of my belief that we are well-equipped to navigate future opportunities and threats to an even greater extent than we were prior to the crisis. Those opportunities and threats are inherent in an incompletely resolved credit picture, untenable extremes in fiscal and monetary policy, and what is - in contrast to early 2009 - a strenuously overvalued, overbought and overbullish equity market.

Market Climate

As of last week, the Market Climate for equities was characterized by an unusually extreme profile of overvalued, overbought, overbullish, rising-yield conditions. Both Strategic Growth and Strategic International Equity remain tightly hedged here.

Following the Federal Reserve's policy meeting last week, Ben Bernanke gave a press conference. From the standpoint of what I continue to view as a terribly reckless policy, Bernanke actually did a fairly good job in that he both avoided any allusion to further rounds of QE while also avoiding any panic about a near-term reversal of the Fed's bloated balance sheet.

Many observers have asked why the Bernanke has initiated this policy of post-meeting press conferences. In my view, it can't be that the Fed wants transparency, given that this is the same Fed that fought to avoid the release of details on the recipients of discount-window borrowing, about 70% which turned out to be foreign banks. It can't be for theoretical reasons, in that economic theory largely suggests that anticipated Fed policy has weaker effects than unanticipated policy. So we are left with the explanation that the objective of the conferences is rhetorical - a "bully pulpit," that substitutes words for suitable policy. Bernanke undoubtedly recognizes that the key event in QE2 was not simply the asset purchases, but his Op-Ed piece in the Washington Post which triggered a speculative rush for "risk" assets and a wave of commodity hoarding. With interest rates at zero and QE already at unstable extremes, the press conferences are a subtle admission that the only remaining policy tool of the Fed is rhetoric.

What is still fascinating to me is that when Bernanke discusses his claims of "success" regarding QE2, nearly every metric he offers is an indicator of financial market distortion instead of real economic activity. After two years of massive Fed intervention, there is waning credibility to the statement that Fed policy "operates with a lag." The questions from reporters, from my perspective, were either softballs or reflected a misunderstanding of how monetary policy operates. My sense is that once the questions begin to ponder the lack of conformity of many of the Fed's actions with the constraints of the Federal Reserve Act (Maiden Lane vs. the word "discount" under the meaning of Section 13, Fannie and Freddie vs. the phrase "agency of the United States" under the meaning of Section 14), Bernanke may find the need to answer reporters' questions to be regrettable.

In bonds, the Market Climate last week was characterized by relatively neutral yield levels and modestly positive yield pressures. New claims for unemployment have picked up again beyond the 400,000 level, and do not yet reflect the pressures we expect on state and local employment beginning about mid-year. Treasury bill yields dropped to less than 3 basis points last week, which is terrible for the elderly and other interest-dependent investors, but is constructive in the sense that it mutes inflationary pressures that would otherwise emerge as a result of the massive outstanding stock of base money (see recent weekly comments for more discussion on this point). The Strategic Total Return Fund presently carries a duration of about 2.5 years, with less than 4% of assets in precious metals shares, where market action appears to be closely tracking a well-defined Sornette-type bubble with a rapidly approaching "finite-time singularity" (see Anatomy of a Bubble ). From a more standard technical perspective, the recent range-expansion within a parabolic trend is suggestive of an "exhaustion rally" in gold and silver. I continue to believe that inflation risk is likely to be concentrated in the second half of this decade, and very much doubt the ability of investors to consistently maintain an inflation thesis in the interim. Historically, the markets have a convincing record of punishing crowded trades.

I should probably note that Greek 2-year government yields have shot to about 24%, compared with about 2% for 2-year German bunds. Assuming a 35% haircut in the event of debt restructuring (65% recovery), that spread implicitly puts the probability of a Greek debt default at [(1-exp(-(.24-.02)*2))/(1-.65) = ] about 100%.

On that subject, Bill Hester presents the interest rate picture from an international perspective in his latest research piece this week: Rising Global Interest Rates Create Headwinds