John Hussman: We Learn From History That We Do Not Learn From History

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

Excerpt from the Hussman Funds' Weekly Market Comment (6/9/14):

“We learn from history that we do not learn from history.”

Georg Wilhelm Friedrich Hegel

Last week, Investors Intelligence reported that bullish sentiment surged above 60%, coupled with a 5-year high in the S&P 500 and valuations beyond 18 times record trailing earnings. The same combination was last seen the week of the October 2007 market peak, last seen before that in January and May 1999 (which we should emphasize was good for only a 5% correction in the short run before a choppy run to the 2000 peak, but would still leave the S&P 500 more than 40% lower three years later), last seen before that the week of the August 1987 pre-crash peak, and last seen before that in January 1973, just before the S&P 500 lost half of its value.

Market conditions presently match those that have repeatedly preceded either market crashes or extended losses approaching 50% or more. Such losses have not always occurred immediately, but they have typically been significant enough to wipe out years of prior market gains. Aside from the 2000-2002 instance, they also have historically ended at valuations associated with prospective 10-year S&P 500 nominal total returns in excess of 10%. At present, reliable valuation measures are associated with estimated total returns for the S&P 500 of just 2.0% annually over the coming decade. On the basis of historically reliable measures, the S&P 500 would have to move slightly below the 1000 level to raise its prospective returns to a historically normal 10% annually. Given short-term interest rates near zero, economic disruptions would probably be required in order to produce that outcome over the completion of the current cycle, and we have no forecast or requirement for that to occur. Of course, there is no shortage of historically unreliable measures available to offer assurance that equity valuations are just fine.

We are emphatic about two points here:
  1. The extreme conditions that we observe today do not necessarily resolve into near-term predictions about market direction. Historically, the most severe overvalued, overbought, overbullish syndromes do not precisely overlap market peaks, and occasionally precede them by months or quarters before they are resolved by steep losses. The eventuality of steep losses is predictable, but the timing is not. Speaking very generally, similar extremes in history followed 5-year diagonal advances and were followed by 2-year collapses. Still, aside from the view that conditions are already extreme and monetary policy is an unreliable and receding support, yield-seeking speculation has played an enormous psychological role in the recent half-cycle, and marking turning points has not been our strong suit;
  2. Our own challenging experience since 2009 is not an adequate reason to ignore the objective historical evidence here. Our experience in recent years is not the reflection of a static investment method. It began with my insistence, at the height of our success in 2009, on ensuring that our methods were robust to Depression-era outcomes. While I saw that as a fiduciary responsibility, the decision immediately resulted in missed gains early in this half-cycle. And while the ensemble methods that we introduced in 2010 performed better in complete historical cycles than any approach we’ve tested, repeated bouts of quantitative easing then required us to reintroduce certain bubble-tolerant features of our pre-2009 methods as an overlay (mostly relating to what we called "trend uniformity" during the late-1990's bubble). The combined result was an unexpectedly difficult and awkward transition from our pre-2009 methods to our present methods. Ironically, both methods of classifying market return/risk conditions capably navigate market cycles across a century of history (though our present methods handle Depression-era data better), including the current cycle, had either method been in practice without that transition (See Setting the Record Straight).

Ongoing research is a central component of our discipline. Where we can identify considerations, supported by historical evidence, that would improve our investment discipline in a way that can be validated across prior market cycles, we eagerly incorporate that new knowledge into our approach. But where we are asked to suspend our respect for the lessons of history, and to embrace speculation on the basis of popular theories that lack support in a century of evidence, we have to refuse. That refusal undoubtedly comes with a price, sometimes to our returns, and often to our popularity. Sometimes our respect for history will harm us instead of helping us, as has been true – at least to date – of my decision to stress-test against Depression-era data. Regardless, we continue to pursue a historically-informed approach in the expectation – vindicated again and again through time – that the benefits of discipline are ultimately greater, and the costs ultimately smaller than the alternative of believing “this time is different.”

With regard to the market outlook, our present views are not built on the forecast that stocks must decline immediately, or that we won’t go through some additional discomfort if the market pushes to a higher peak. Still, a century of history strongly warns that whatever transitory gains the market achieves from present levels will be wiped out in spades, with little opportunity (particularly given thin trading volume) for more than small set of investors to actually retain those gains over the completion of this cycle.