John Hussman: Monitoring Goldilocks

by: John Hussman

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

In its latest weekly report, Vickers noted that among stocks traded on the NYSE, corporate insiders sold 6.50 shares for every share purchased, compared with a ratio of 3.02 the prior week. The 8-week average for NYSE/ASE listed stocks is now 3.94 and rising, with an 8-week ratio of 3.39 for the Nasdaq. Insider selling isn't a very precise indicator of near-term market action, but has a decent record of preceding flat or declining markets, often with a lead-time of several months.

The American Association of Individual Investors shows bullish sentiment among investors at the highest level since the market's May high. Overall, indicators of sentiment are elevated enough to suggest either a flattening of returns or a potential correction, but it's difficult to take them as urgent warning signals.

Major shifts in market direction are typically related to a change in the "theme" that investors have adopted. During the late 1990s, for example, the prevailing theme was that technology had created a "new era" in which old valuation metrics simply didn't apply, and where earnings could advance at 30% annual rates indefinitely. During the fourth quarter of 2000, investors were suddenly shocked as companies began to lower earnings guidance. Over the following two years, they learned the lesson (now long forgotten) that profit margins are cyclical and rich valuations rarely persist.

The strength of the market over the past few months has been fueled almost entirely by the belief that the economy has entered a "soft landing" where earnings will continue to grow, profit margins will remain strong, and high oil prices are behind us. There is no allowance for any narrowing of profit margins, much less reductions in valuation multiples. If anything, analysts these days are pushing the idea that a "Goldilocks" economy will prompt the Fed to cut interest rates, which they assume will automatically translate into even higher P/E multiples on record earnings on record profit margins.

So the real question, in my view, continues to be whether the "Goldilocks" scenario, which the market has adopted part-and-parcel, will be rejected by the data over the next few months. It's clear enough from current market action that investors are in a speculative mood, but we don't have much information about when (or how abruptly) the "Goldilocks" theme might be contradicted by new evidence.

As I've emphasized in recent comments, I believe that the theme is wrong. But that doesn't require us to hope for bad news or to "fight" prevailing market action. At the same time, we don't want to base our investment positions on an improbable theme if those investment positions would lead to material losses if that theme turns out to be wrong.

Given low option volatilities and the correspondingly low cost of option premium, I believe the best response is to accept market exposure through "one-sided" positions such as call options, without compromising downside protection.

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