John Hussman: Unhealthy Market Exuberance

by: John Hussman

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

Last week, the Financial Times ran the following news comment: “Aronson&Johnson&Ortiz, a Philadelphia fund manager, has for years tracked a simple strategy: buy the cheapest 10 percent (as measured by the multiple of price over earnings) of the 2000 largest stocks in the market, and sell short the most expensive 10 percent. Over time this strategy does well. Since the exercise started in 1962, it gained about 1200 percent (8.4 percent annually). This strategy is highly unlikely to lose money. It has only done so when the market is truly out of whack, with the most expensive stocks carried forward by their own momentum. A fall in the AJO strategy indicates a major sell-off is in the making. Ahead of the bursting of the internet bubble in early 2000, it dropped 53 percent – an early warning of the juddering halt that lay ahead. Since February 2000, it has gained 380 percent, while the S&P 500 has been flat. So it should cause concern that the AJO strategy is now falling, for the first time since 2000. It fell ahead of May's correction, and rose thereafter as the rally gained strength, before falling again. By the end of October, it was more than 10 percent below its peak set early last year. The dearest stocks are once more strongly outperforming the cheapest. This is unhealthy. It suggests a correction may be coming sooner rather than later.”...

Here in our office, Bill Hester makes a hobby of reading through 13-F filings. In recent weeks, he's noted an increase in the number of hedge funds holding the SPDRs (S&P 500 depository receipts – essentially exchange traded index funds). In effect, Bill says, “it looks like they're so eager to get into the market that they've bypassed stock selection altogether.” It's difficult for good stocks to get much traction on the basis of their investment merit if investors don't even stop to discriminate...

The more-than-doubling of the NYMEX initial public offering on Friday was also interesting. The equities of securities exchanges like the NYSE and NASDAQ, among others, have soared lately. Among offbeat indicators of sentiment used to be the price of seats on the NYSE (which are now no longer traded). Soaring seat prices were generally a good sign of the exuberance of market tops. Friday's NYMEX “shooter” brought that element together with a bubbling IPO market, and is an indication of the increasingly speculative tone of the stock market here.

All of that said, it's exactly that speculative tone, evident in the ease of market advances and the lack of “heavy” price-volume action, which prevents any good forecast of when the market will turn down or complete its cycle. Still, as long-term investors, we don't really need to know. Once stocks become richly valued, further market gains are typically not retained over the full cycle. In richly valued markets, the primary source of sustainable returns is good stock selection that is hedged against general market fluctuations, plus the implied interest earned on those hedges.

Read more John Hussman weekly essay excerpts on Seeking Alpha.