John Hussman: Time To Watch For Falling Rocks

by: John Hussman

Excerpt from fund manager John Hussman’s weekly essay on the US market:

For an investor looking to capture all the market's long-term returns with substantially less downside risk, it would actually have been enough, historically, to simply step out of the market on a price/peak multiple of 19 and then wait for a 30% plunge before repurchasing stocks, even if that meant staying out of the market for years in the interim. (As I've also noted, this is not a practical or optimal strategy by any means, since it has far too much tracking risk and would have required implausible levels of patience, but it's an enlightening fact nonetheless).

It doesn't help the case for stocks to argue that, for example, earnings growth is still positive, because it turns out that the year-to-year correlation between stock returns and earnings growth is almost exactly zero. It doesn't help to argue that consumer confidence is still high, because consumer confidence is actually a contrary indicator, as are capacity utilization, the ISM figures, and other factors being used for bullish fodder. It doesn't help to argue that the Fed will stop tightening soon, because the end of a tightening cycle has historically been followed by below-average returns for about 18 months.

It doesn't help that 10-year bond yields are higher than the prospective operating earnings yield on the S&P 500 (the “Fed Model”), not only because the model is built on an omitted variables bias (see the August 22 2005 comment), but also because the model statistically underperforms a simpler rule that says “get in when stock yields are high and interest rates are falling, and get out when the reverse is true.”

Once stocks are richly valued, then, the burden of proof is on the case for staying in, not getting out. Once interest rates are rising, that burden of proof ticks up. Once internals show “heavy” price/volume behavior, more burden. And once you get a huge leadership reversal, as we've seen over the past week, it's time to watch for falling rocks...

It's only been 10 trading days since the S&P 500 registered 5-year highs and the Dow hit 6-year highs. The S&P 500 has since declined by 4.43%, is oversold, and could very well be due for a short-term bounce. On that basis, the preceding comments may seem overwrought. Nevertheless, current conditions strike me as so canonically unfavorable that they demand some additional emphasis of the risks involved. We don't rely on negative market outcomes here. But we shouldn't be surprised if the next few months are substantially more difficult for the major indices than anything investors have observed in recent years.