John Hussman: Risk vs. Reward in an Overbought Market

by: John Hussman

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

While the fanfare accompanying each marginal new high in the market gives the impression that stocks are making important gains, the issue for a long-term investor must always be whether such gains are likely to be retained over the full market cycle.

Investors are eager to overlook the fact that stocks have lagged risk-free Treasury bill returns over the past 8 years, and are instead focused on the gains achieved during the current bull market. Yet even over the most recent 2.8 years since early 2004, the major indices have outperformed Treasury bills by only about 5% annually.

Now, 5% annually, retained over the full market cycle, is a respectable margin over risk-free rates. But here the 5% margin has applied to a bull-market-only portion of this cycle, where bull-market-only gains have historically outpaced T-bill yields by upward of 20% annualized, on average. Worse, with stocks strenuously overbought and trading at rich multiples on record profit margins, there's a very slim potential for investors to retain that 5% margin they've earned above T-bill yields during the past few years.

Think about it this way. Suppose that the market achieves a 15% total return over the coming year, finally followed in the next year by a shallow one-year correction of just 16%. The combination of that mild "cycle completing" decline, along with the passage of time, would still be enough to put T-bills ahead of stocks not only for the period since early 2004, but for what would then be a full decade since 1998. The only advantage over T-bill yields that this bull market has a reasonable shot of retaining is the gain that occurred between late 2002 and early 2004 (even that portion would largely vanish in anything but a mild "cycle completing" bear market).

It's tempting to think that the reasonableness of a defensive stance here depends on whether the market will make further new highs in the near term. But that ignores the fact that the only way to retain further gains here -- without giving them back during the completion of this market cycle -- is to exit at even higher prices. And the trouble is that if investors accept risk here, despite an overvalued, overbought and overbullish investment environment, they can't use any of those conditions as exit criteria. A move to overvaluation won't get them out, because the market is already overvalued.

Given that current valuations don't provide an adequate investment basis for taking market risk, and market action is already overextended, the only plausible exit signal for a speculative position has to be a deterioration of market action. Logically, then, the case for taking risk at present has to be that either a) the market will not experience any material correction in the coming years despite current valuations, or b) that the market is likely to move so much higher here that even a deterioration that triggers an exit will still provide a higher sale than at present. Those aren't impossible, but we certainly wouldn't risk a great deal of capital on them...

With the Dow and S&P 500 at similar levels to their 2000 peaks, we're about high enough to hear echoes across the canyon. The "Dow 36,000" bit is starting to get ink again from the press, which is kind of scary. We're also starting to hear murmurs about a shadowy "plunge protection team" -- both from bulls hoping that someone is standing there to save them from potential losses (investors believed the same thing in '29), and from bears believing that the persistence of the recent advance is a sign of manipulation.

I don't really give much weight to these arguments. It's certainly possible to manipulate a thinly traded security or even spike a futures market from time-to-time. But in a market that regularly trades nearly 2 billion shares a day just on the NYSE, it would require implausibly large concentrations of capital to support the market with purchases in the face of a sustained willingness of investors to sell. Even the total amount of bank reserves overseen by the Federal Reserve is just $43 billion, in an economy with a GDP of $13 trillion and a similarly large stock market capitalization.

What we observe as persistence and uniformity is a standard feature of markets where speculators have acquired a "taste" for risk-taking. We can measure it, we're seeing it at present, and it's capable both of ending abruptly and of continuing for a while. My impression is that this speculative mood is less reflective of manipulation than it is the adoption of a common "theme." We saw it with the "new era /" theme 6 years ago, and we've got it with Goldilocks today. Still, none of that changes the fundamentals, nor the fact that markets have a strong tendency to fluctuate around fundamentals -- both above and below -- over time...

Adding to the general impression of an overextended stock market, Vickers notes that corporate insiders of stocks traded on the NYSE ramped up their selling activity last week to 7.81 shares sold for every share bought. On the Nasdaq, the insider sell/buy ratio shot to 6.36. Both ratios have more than doubled over the past few weeks. One wonders, if corporate insiders have so little optimism about their own shares, why should investors?

Read more John Hussman weekly essay excerpts on Seeking Alpha.