John Hussman: A Hint Of Advance Warning

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

Excerpt from the Hussman Funds' Weekly Market Comment (8/4/14):

Historically-informed investors are being given a hint of advance warning here, in the form of a strenuously overvalued market that now demonstrates a clear breakdown in internals. We observe these breakdowns in the form of surging credit spreads (junk bond yields versus Treasury yields of similar maturity), weakness in small capitalization stocks, and other measures. These divergences have actually been building for months, but rather quietly. Note, for example, that as the S&P 500 pushed to new highs in recent weeks, cumulative advances less declines among NYSE stocks failed to confirm those highs, while junk bond prices were already deteriorating. We don’t take any single divergence as serious in itself, but the accumulation of divergences in recent weeks should not be ignored. Notably, the majority of NYSE stocks are now below their respective 200-day moving averages (which again, isn’t serious in itself, but feeds into a larger syndrome of internal breakdowns in a market that remains strenuously overvalued).
In the late-1990’s and during the 2000-2002 market plunge, we generally referred to the presence or lack of internal divergences with the phrase “trend uniformity.” In that cycle, those measures actually shifted negative just as the S&P 500 itself was peaking (see my September 4, 2000 market comment). As I observed in 2001, “It is crucial to understand that trend uniformity is not based on the extent or duration of a market advance. Rather, trend uniformity measures the quality of an advance. Without disclosing anything proprietary, trend uniformity considers the market action of a wide range of market internals, industry groups, and security types. Most legitimate and sustained bull moves very quickly generate trend uniformity, which I interpret as a signal that investors have developed a robust preference for taking risk. Some advances never generate this, as we saw between March and May this year. Those rallies are suspect, because there is a skittishness underlying them. When you have unfavorable trend uniformity in an overvalued market, the situation is very vulnerable because there is no natural floor to support prices.”

A reminder - much of our stress-testing following the expected collapse of the market in 2008 was related to those measures of “early improvement” in market action. Both Depression-era data and the credit crisis required broader and more robust measures than were typically required in post-war data (it’s instructive to review how we walked into that challenge in late-2008 after the market plunged and we made an initial constructive shift – see Why Warren Buffett is Right and Why Nobody Cares). There’s no question that my stress-testing decision in 2009 set off a very challenging experience in recent years, both because of our 2009-early 2010 miss in the interim of that stress testing, and also because extreme overvalued, overbought, overbullish syndromes have persisted much longer, without resolution, in the present cycle than they have historically. We’ve addressed those challenges, but without a time-machine we can only demonstrate that going forward. Meanwhile, our valuation measures have been consistently reliable for a century with respect to 10-year and full-cycle market returns, and they have not missed a beat even in recent cycles. Don’t make the mistake of believing that our valuation concerns today can be dismissed on the basis of that stress-testing miss.

The key point is this: after an extended and extreme compression of risk premiums, we’re now observing increasing divergences across a variety of market internals and security types (e.g. breadth, leadership, momentum stocks, small caps, junk bonds). We’ve come to avoid pointed warnings in this market, because speculative conditions have extended much longer than in other cycles. Indeed, we’ve had a few deteriorations in recent years that reversed fairly quickly as investors shifted back to risk-seeking, particularly after fresh initiatives or assurances about monetary easing (though further initiatives may not be forthcoming in this instance). So we're open to a favorable shift on these measures, and if that was to occur following a somewhat greater retreat in valuations, it could even open up some amount of constructive opportunity. Meanwhile, despite our view of stocks as severely overvalued, our response is to remain defensive without taking a stance that greatly relies on immediate market weakness.