John Hussman: Goldilocks or the Wait-and-See Bears?

by: John Hussman

Excerpt from fund manager John Hussman's weekly essay on the U.S. market:

Investors seem to be placing a great deal of hope in the idea that the Fed is done tightening. The basic scenario is that the economy is slowing modestly, so inflation pressures will slow as well, allowing the Fed to cut interest rates while earnings continue to grow...

Historically, if we look at points where the Fed has cut rates at least twice, it has invariably been either during or just prior to a period of substantial earnings weakness. We don't typically observe strong earnings growth coupled with fresh Fed loosening cycles, except on the back-side of recessions.

Similarly, since July, we've observed an inverted yield curve, with the 10-year Treasury yield below the 3-month Treasury bill yield. Bill Hester observed last week that whenever the Fed has raised the discount rate by at least 1%, ending in a yield curve inversion for more than a few weeks, the U.S. economy has entered a recession after a median lag of 8 months...

On the valuation front, the current P/E ratio for the S&P 500 is 18 times record earnings (on record profit margins). Historically, the combination of an inverted yield curve and a P/E ratio over 15 has been associated with negative market returns, on average. The only time we've observed an inverted yield curve and a P/E at or above 18 times record earnings was at the 2000 market top. The runner-up (just below 18) was near the heights of the “Go-Go” market leading into the '69-'70 bear market.

All of that said, there are two factors on the side of a speculative position. First, our measures of sponsorship (particularly those associated with price-volume behavior) have improved moderately in recent days. Whether or not we agree with the market's “Goldilocks” thesis, the fact is that investors have put at least some sponsorship behind it lately.

The second constructive factor these days is the seasonal pattern that Bill Hester noted in his piece on the 4-Year Cycle last December. In post-war data, there have been 15 favorable seasonal periods running from October of the 2nd year of a presidential term, through September of the 3rd year. That's the seasonal period we've just entered. Of those periods, not one has seen a market loss. Indeed, the average gain has been nearly 30% annualized.

Of course, there's a distinction between analysis and superstition...

In 12 of the 15 cases, the S&P 500 had been at least 10% below its prior 52-week high within several weeks (and no more than 6 months) before the seasonally favorable period. At present, the market is strenuously overbought, and long overdue for a 10% correction.

Of the 11 recessions in the post-war period, 9 were in force a year or less prior to the seasonally favorable period. Evidently, the majority of the strength was linked to post-recession recovery momentum.

Only 4 of these periods began at P/E ratios above 15 on the S&P 500, and of those, none began with the S&P 500 above its 6-month moving average (as it clearly is at present). Once again, you generally build sustained rallies off of prior losses, not off of overextended advances.

Of the 9 cycles since 1963 (when Investors Intelligence began publishing its advisory sentiment data), all but one began at a lower level of advisory bullishness than today...

Meanwhile, John Mauldin's weekly newsletter quoted Fed Vice-Chairman Donald Kohn (who spoke Tuesday night at New York University): "In the current circumstances, the upside risks to inflation are of greater concern... I am surprised at how little market participants seem to share my sense that the uncertainties around these paths and their implications for the stance of policy are fairly sizable at this point."

Mauldin's recent pieces have highlighted the rate of inflation in personal consumption expenditures (which was Alan Greenspan's preferred inflation measure)... Mauldin also reports a Fed statistic called the “trimmed mean PCE.” This attempts to find the “central tendency” of inflation based on the average inflation rate in PCE components after trimming away the components that are unusually extreme (positive or negative) each month. In other words, it's more robust than the raw PCE. Statistically, it also turns out to be a better measure of underlying inflation trends. Note that on a 6- and 12-month basis, the trimmed mean PCE inflation rate has not slowed at all.

Read more John Hussman weekly essay excerpts on Seeking Alpha.