For context, John offers a brief history lesson for the goldfish-like memories of Wall-Street-wannabes and head-in-sand home-gamers who have forgotten what it was like in 2000 and 2007…
At the height of the technology bubble, the median of the most reliable market valuation measures we follow (those most strongly correlated with actual subsequent S&P 500 total returns) briefly reached an apex 178% above historical norms that had been regularly approached or breached over the completion of every market cycle in history.
That level of valuation implied a prospective market loss of (1/(1+1.78)-1 = ) -64% as the bubble collapsed.
Attempting to “stimulate” the economy from the recession that followed, the Federal Reserve cut short-term interest rates to just 1%, provoking an episode of yield-seeking speculation, where yield-starved investors created demand for higher-yielding mortgage-backed securities, and a weakly-regulated Wall Street rushed to create new “product” to meet the demand (by lending to anyone with a pulse).
At its peak, the resulting bubble took the median of the most reliable market valuation measures we follow to a level more than 95% above their historical norms, implying a prospective market loss on the order of -49% as that bubble collapsed.
Again attempting to “stimulate” the economy from the recession that followed, the Federal Reserve cut short-term interest rates to zero in recent years, provoking yet another episode of yield-seeking speculation, where yield-starved investors created demand for virtually every class of securities, in the hope of achieving returns in excess of zero. Meanwhile, Wall Street, suffering from what J.K. Galbraith once called the “extreme brevity of the financial memory,” convinced itself yet again that the whole episode was built on something more solid than quotes on a screen and blotches of ink on paper.
At last week’s highs, the median of the most reliable market valuation measures we follow reached an extreme that placed them 170% above their historical norms, implying a prospective market loss on the order of -63% in what I fully expect to be the collapse of the third speculative bubble since 2000.
One look at the chart below and even Bob Pisani can see something is not different this time…
The chart above presents some of these valuation measures. Note that even if the completion of this cycle leaves these measures 25% above their historical norms, the resulting market decline would amount to about (1.25/2.70-1 =) -54%, while even a decline that leaves valuations still 50% above their norms would represent a market loss in excess of -44%. Aside from shorter-term bursts of speculative enthusiasm, even low interest rates are not likely to mitigate full-cycle market losses, because over time, the benefits of low rates are typically offset by the disappointing economic growth that produces them (see Rarified Air: Valuations and Subsequent Market Returns for a deep dive into these relationships).
It’s important to be very clear on this point: a market loss between -44% and -63% over the completion of this cycle would not represent a worst-case scenario, but instead an ordinary, pedestrian, historically run-of-the-mill outcome given current valuation extremes.
And so having explained methodically just how extreme the current level of US equity market overvaluation is, Hussman takes aim at the culprit (or culprits)
But see, greater real economic activity was never the likely outcome of all this quantitative easing (indeed, one can show that the path of the economy since the crisis has not been materially different than what one could have projected using wholly non-monetary variables).
Rather, Ben Bernanke, in his self-appointed role as Mad Hatter, was convinced that offensively hypervalued financial markets – that encourage the speculative misallocation of capital, imply dismal expected future returns, and create temporary paper profits that ultimately collapse – somehow represent a greater and more desirable form of “wealth” compared with reasonably-valued financial markets that offer attractive expected returns and help to soundly allocate capital.
Believing that wealth is embodied by the price of a security rather than its future stream of cash flows, QE has created a world of hypervaluation, zero prospective future returns, and massive downside risks across nearly every conventional asset class.
And so, the Fed created such an enormous pool of zero interest bank reserves that investors would feel pressure to chase stocks, junk debt, anything to get rid of these yield-free hot potatoes. That didn’t stimulate more real, productive investment; it just created more investors who were frustrated with zero returns, because someone had to hold that base money, and in aggregate, all of them had to hold over $4 trillion of the stuff at every moment in time.
When you look objectively at what the Fed actually did, should be obvious how its actions encouraged this bubble. Every time someone would get rid of zero-interest base money by buying a riskier security, the seller would get the base money, and the cycle would continue until every asset was priced to deliver future returns near zero. We’re now at the point where junk yields are among the lowest in history, stock market valuations are so extreme that we estimate zero or negative S&P 500 average annual nominal total returns over the coming 10-12 year horizon, and our estimate of 12-year prospective total returns on a conventional mix of 60% stocks, 30% Treasury bonds, and 10% Treasury bills has never been lower (about 1% annually here).
This whole episode is likely to end so badly that future children will learn about it in school and shake their heads in wonder at the rank stupidity of it all, just like many of us did when we learned about the Dutch Tulip mania.
Hussman finishes with some sanity for everyone…
Examine all risk exposures, consider your investment horizon and risk-tolerance carefully, commit to the flexibility toward greater market exposure at points where a material retreat in valuations is joined by early improvement in market action (even if the news happens to be very negative at that point), fasten your protective gear, and expect a little bit of whiplash.
Remember that the “catalysts” often become evident after prices move, not before. The completion of this market cycle may or may not be immediate, but with the median stock at easily the most extreme price/revenue ratio in history, and a run-of-the-mill outcome now being market loss on the order of -60%, the contrast between recent stability and likely future volatility could hardly be more striking.