John Hussman: Setting The Record Straight

Includes: DIA, IWM, QQQ, SPY
by: John Hussman

Excerpt from the Hussman Funds' Weekly Market Comment (5/12/14):

With advisory sentiment running at 56% bulls and fewer than 20% bears, with most historically reliable valuation metrics about twice their pre-bubble norms (and presently associated with negative expected S&P 500 nominal total returns on every horizon of 7 years and less), with capitalization-weighted indices near record highs but smaller stocks and speculative momentum stocks diverging badly, and with a Federal Reserve clearly intent on winding down the policy of quantitative easing that has brought these distortions about, we continue to view the present market environment as among the most dangerous instances in history.

Major market peaks, even those like 2000 and 2007 that were followed by 50% losses, have never felt dangerous at the time. That’s why they were associated with exuberant price extremes. Sure, investors had a sense that prices had advanced a great deal, but endless reasons could be found to justify the advance. Avoiding major losses required an intimate familiarity with market history, and enough discipline and patience to maintain what Galbraith called a “durable sense of doom” about observable conditions. The general rule is that you don’t observe the “catalyst” in advance, only the stack of dynamite.

Over the years, we’ve repeatedly emphasized that the very best investment opportunities are associated with a significant retreat in valuations that is then coupled with early improvement in market internals across a broad range of stocks, industries, and security types. Conversely, the very worst market outcomes are associated with overvalued, overbought, overbullish conditions that are then coupled with divergences in market internals and a loss of uniformity (as we observe today). As I wrote in October 2000, “when the market loses that uniformity, valuations often matter suddenly and with a vengeance. This is a lesson best learned before a crash rather than after one.”

None of the market cycles we’ve observed in recent decades have been exceptions to these general rules. It’s true that investor enthusiasm about the novelty and size of quantitative easing has prolonged speculative extremes beyond most prior instances, but understand that those prior instances are limited to 1929, 1972, 1987, 2000, 2007 and a brief point in 2011 that was followed by a near-20% market retreat (see It is Informed Optimism to Wait for the Rain). To the extent that speculative pressures have pushed further in the broad stock market, the eventual payback is likely to be distressing.


Setting the record straight

It may be helpful to set our longer-term record straight, as it may explain why we are so confident in pursuing our full-cycle discipline here. With one primary exception, that record is a chronicle of becoming constructive or aggressive when improved valuations are coupled with early improvement in market action, and becoming defensive when overvalued, overbought, overbullish conditions emerge – particularly once market internals lose uniformity and become divergent.

Following the 1990 bear market, these considerations allowed me for years to be a leveraged, “lonely raging bull” (in the words of the Los Angeles Times). As the decade continued and valuations became progressively extreme, market conditions gradually moved us to a highly defensive stance in the late-1990’s. We were certainly early, but the market collapse that followed wiped out the entire total return of the S&P 500, in excess of the return on Treasury bills, all the way back to May 1996. Whatever returns we missed from not joining the speculation were ripped from the portfolios of others by the end of the 2000-2002 bear market anyway, and our approach navigated that market decline quite nicely, thank you.

Following the 2000-2002 bear market, we shifted to a constructive stance, observing “we have no evidence to hold anything but a constructive position.” Though valuations weren’t particularly attractive, the shift was based – not surprisingly – on a significant retreat in valuations coupled with early improvement in market internals. As valuations became progressively extreme, we moved back to a highly defensive position. The market collapse that followed would wipe out the entire total return of the S&P 500, in excess of the return on Treasury bills, all the way back to June 1995. Remember – risk management is generous. As I noted approaching the 2007 peak (see Rip Van Winkle), whatever returns that disciplined, value-conscious investors “miss” in overvalued markets are rarely retained by other investors anyway.


“Monetary Policy Going Forward: De-Spiking the Punch Bowl 10 Ounces at a Time”

The header above is from a speech on Friday by FOMC voting member Richard Fisher. Take a moment to understand what he is saying (emphasis added):

“The Federal Open Market Committee (FOMC) is in the process of winding down its massive purchases of Treasuries and mortgage-backed securities. At our last meeting, in recognition that the economy is improving and acknowledging that we have generated massive amounts of excess reserves among depository institutions operating in the U.S., we voted to reduce our purchases to a combined $45 billion per month, on the path to eliminating them at the earliest practicable date. Speaking only for myself as a voting member, barring some destabilizing development in the real economy that comes out of left field, I will continue to vote for the pace of reduction we have undertaken, reducing by $10 billion per meeting our purchases and eliminating them entirely at the October meeting with a final reduction of $15 billion.

“I was not for this program, popularly known as QE3, to begin with. I doubted its efficacy and was convinced that the financial system already had sufficient liquidity to finance recovery without providing tinder for future inflation. But I lost that argument in the fall of 2012, and I am just happy that we will be rid of the program soon enough.

“I am often asked why I do not support a more rapid deceleration of our purchases, given my agnosticism about their effectiveness and my concern that they might well be leading to froth in certain segments of the financial markets. The answer is an admission of reality: We juiced the trading and risk markets so extensively that they became somewhat addicted to our accommodation of their needs… you can’t go from Wild Turkey to cold turkey overnight. So despite having argued against spiking the punchbowl to the degree we did, I have accepted that the prudent course of action and the best way to prevent the onset of market seizures and delirium tremens is to gradually reduce and eventually eliminate the flow of excess liquidity we have been supplying… one would be hard pressed to say that ending our asset purchases, which the depository institutions from which we buy them deposit back with us as excess reserves, would deny the economy needed liquidity. The focus of our discussions now is when and how to ‘normalize’ monetary policy.”