John Hussman: The Dangers of Chasing The Bull

by: John Hussman

Excerpt from fund manager John Hussman's weekly essay on the U.S. market:

With stocks still near their recent highs, I think it's useful to remember the tendency of bull markets to surrender large portions of their gains over the full market cycle. Without that understanding, investors are vulnerable to the temptation to "chase" returns in what is already a richly valued, aged bull market advance, where recession risks continue to gradually increase.

The table below lists a dozen market advances that have accounted for all of the net postwar gain in the S&P 500 index. The table is based on weekly data, with market declines of at least 10% separating the advances.

"Bull Gain" represents the bull-market-only portion of a cycle, while "Full Cycle" shows the portion of the gain that was still retained when the market reached its subsequent low. P/PE shows the price/peak earnings multiple of the S&P 500 at the start and end of those bull runs.

Bull Market Table 6 11 06

A few recognized bull market advances aren't included in the table at all. These include the rallies from May 1970 to April 1971, from November 1971 to December 1972, and from September 1998 to March 2000, all whose gains were entirely wiped out by subsequent declines. (The peak date of 10/27/06 is provided only for reference, not as a market call.)

A few things are worth noticing. First, when we include those periods where bull gains were completely eliminated by subsequent declines, we find that less than half of bull market gains are typically retained over the full market cycle. As I noted two weeks ago, if we take the market's advance from October 1990 through March 2000 as a single bull run, we find that the ensuing decline took the S&P 500 from a bull market return of over 500% to a full cycle return of about 240%. It just doesn't pay to frantically chase the tail of a bull market, particularly once stocks have become richly valued.

Second, notice that bull markets don't start or end at set multiples. Loosely speaking, rallies often started at price/earnings ratios of 11 or less (often in the single digits), and usually ended by the time price/peak earnings ratios approached 17-19 (though the average is closer to 15). Even so, the bull gains have a 90% correlation with the extent to which P/E multiples increased, which was clearly easier when valuations began at low levels. By comparison, the most recent bull market advance from the October 2002 low began at 15.3 times peak earnings, already the highest multiple on record for the start of a bull market advance. The multiple is now in the upper range where prior bull advances have ended.

Looking at the table, you'll note that only three of the bull market periods retained more gains than what the S&P 500 has already achieved in this advance, and all three involved a more than doubling of the market's P/E ratio from a low starting level. It seems unrealistic optimism to expect the market to make further upside progress from here, and actually keep it over the completion of this market cycle, or without at least a 10% correction. Indeed, all of the prior rallies that ended at a P/E above 18 were followed by declines of at least 25%.

Moreover, the current multiple of 18.4 is actually much more extreme than it appears, because that elevated multiple is being applied to an earnings figure based on record profit margins. Historically, investors have not been rewarded for paying rich multiples on rich profit margins. We're already observing "surprising" wage inflation which is likely to place downward pressure on these margins.

At points like this, our investment approach takes the potential risk of market losses very seriously. When there is a high likelihood of further market gains being erased over the complete cycle, then accepting market risk is not an "investment" proposition, but a "speculative" one.

Read more John Hussman weekly essay excerpts on Seeking Alpha.