How to Spot a Bear Market -- John Hussman

by: John Hussman

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

Bear markets don't happen because stock market investors decide, in masse, to go into bonds, or money market funds, or other vehicles. They don't happen because there is more selling than buying...or more money going out than coming in. Rather, they happen because, at prevailing prices, sellers are more eager to liquidate stock than buyers are to purchase stock, so prices have to fall enough so that, at the new prices, the amount of stock that sellers wish to liquidate is exactly equal to the amount of stock that buyers wish to purchase...

So where else are investors going to go? The whole phrasing of the question is preposterous, but consider the following calculation. The S&P 500 currently trades at 19.3 times peak earnings (trailing GAAP basis), compared with a historical average for the price/peak earnings ratio of about 14, and if we only look at points where earnings were actually at fresh peaks, a historical average closer to 12. Suppose that earnings, currently right at the robust 6% trendline connecting S&P 500 earnings peaks from economic cycle to cycle across history, continue to grow along the peak of that historical channel over the next 5 years, and that the price/peak earnings ratio at that point touches, merely touches, a level of 16 – still well above historical norms. Given a current dividend yield of 1.84%, the resulting 5-year total return would be:

(1.06)(16/19.3)^(1/5) + .0184(19.3/16+1)/2 – 1 = 4.13%

… which is about what you can expect from money market funds.

This isn't a timing argument, because the quality of market action is at worst mixed, and investors may very well have some speculation left in them. Unfortunately, speculation at this point will simply cause further deterioration in the long-term returns that stocks are priced to deliver. It's not necessary for investors to actually shift from stocks to money market funds (in fact, it's impossible for them to do so, in aggregate). All that's required for a “bear market