While the latest extreme move higher in the stock market has been greeted with great enthusiasm by mainstream analysts, our analysis suggests that the market is poised for another severe decline similar in character to the corrections in 2010 and 2011. In his latest weekly commentary, fund manager John Hussman issued a similar warning, noting that the current risk/reward profile of the stock market is one of the worst in the history of their data.
Last week, the estimated return/risk profile of the S&P 500 fell to the worst 2.5% of all observations in history on our measures. This is not a runaway bull market. Rather, it is a market that again stands near the highs of an extended but volatile trading range. I am convinced that the breakdown of the market from this range has been deferred only through repeated and extraordinary central bank actions.
Importantly, the market is again characterized by an extreme set of conditions that we've previously associated with a "Who's Who of Awful Times to Invest." The rare instances we've seen this syndrome historically are reviewed in that previous weekly comment. They include the 1972-73 and 1987 market peaks, and several instances since 1998. The more recent instances of this syndrome are shown by the blue bands on the chart below. Each of the separate instances in the 1998-2000 period were followed in short order by intermediate market declines of between 10-18%, and of course, ultimately by a plunge of more than 50% in 2000-2002. Likewise, the 2007 instance was followed in short order by a correction of nearly 10%, and a few months later by a plunge of more than 50% in 2007-2009. The more recent instances in 2010 and 2011 have also been followed by substantial market selloffs in each case, though with a longer lag in 2011 (due to ongoing QE2 operations). Aggressive monetary policy did not prevent the ultimate declines, though massive central bank interventions have undoubtedly helped to short-circuit the more violent follow-through that occurred in 1973-1974, 1987, 2000-2002, and 2007-2009, at least to-date.
A word of caution. While a few of the highlighted instances were followed by immediate weakness, it is more typical for these conditions to persist for several weeks and even longer in some cases (for example, the wide blue strip in late-2010 and early 2011). When we look at longer-term charts like the one above, it's easy to see how fleeting the intervening gains turned out to be in hindsight. However, it's easy to underestimate how utterly excruciating it is to remain hedged during these periods when you actually have to live through day-after-day of advances and small incremental new highs that are repeatedly greeted with enthusiastic headlines and arguments that "this time it's different."
As Hussman notes, an overextended rally of this character has a tendency to continue making marginal new highs until it abruptly breaks down, oftentimes retracing many weeks of gains in a few sessions.
Additionally, as we noted in a recent short-term forecast, the character of the forthcoming decline will provide the next meaningful signal with respect to long-term direction, so it will be important to monitor market behavior closely during the next several weeks.
Subscribe to our RSS Feed to receive free market updates.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.