Why The Fed Can't See A Bubble In Equity Valuations

Tyler Durden's picture

In 'An Open Letter To The FOMC' John Hussman lays out in detail the true state of the world that asset-gatherers and Fed members alike seem blinded to. The intent of his letter is not to criticize, but hopefully to increase the mindfulness of the FOMC as to historical evidence, the strength of various financial and economic relationships, and the potentially grave consequences of further extreme and experimental monetary policy. Crucially, as we have heard numerous times in the last few weeks, the Fed sees no bubble, and so, a courtesy to both the investing public and the gamblers at the Fed, Hussman explains the reason that the Fed does not see an “obvious” stock market bubble (to use a word regularly used by Governor Bullard, as if to imply that misvaluations cannot exist unless they smack their observers with a two-by-four).


Excerpted from John Hussman's "Open Letter To The FOMC",



The reason that the Fed does not see an “obvious” stock market bubble (to use a word regularly used by Governor Bullard, as if to imply that misvaluations cannot exist unless they smack their observers with a two-by-four) is because while price/earnings multiples appear only moderately elevated, those multiples themselves reflect earnings that embed record profit margins that stand about 70% above their historical norms.

We can demonstrate in a century of evidence that a) profit margins are mean-reverting and inversely related to subsequent earnings growth, b) margin fluctuations are largely driven by cyclical variations in the combined savings of households and government, and importantly, c) valuation measures that normalize or otherwise dampen cyclical variation in profit margins are dramatically better correlated with actual subsequent outcomes in the equity markets.




A few additional charts will drive this point home. The chart below shows the S&P 500 price/revenue ratio (left scale) versus the actual subsequent 10-year nominal total return of the S&P 500 over the following decade (right scale, inverted). Market valuations on this measure are well above any point prior to the late-1990’s market bubble. Indeed, if one examines the stocks in the S&P 500 individually, the median price/revenue multiple is actually higher today than it was in 2000 (smaller stocks were more reasonably valued in 2000, compared with the present). This is a dangerous situation. In this context, the dismissive view of FOMC officials regarding equity overvaluation appears misplaced, and seems likely to be followed by disruptive financial adjustments.



One obtains a similar view, with equal historical reliability, from the ratio of nonfinancial equity capitalization to nominal GDP, using Federal Reserve Z.1 Flow of Funds data. On this measure, equities are already beyond their 2007 peak valuations, and are approaching the 2000 extreme. The associated 10-year expected nominal total return for the S&P 500 is negative.



The unfortunate situation is that while the required financial adjustment may or may not be as brutal for investors as in 2007-2009, or 2000-2002, or 1972-1974, when the stock market lost half of its value from similar or lesser extremes, the consequences of extremely rich valuation cannot be undone by wise monetary policy. The Fed has done enough, and perhaps dangerously more than enough. The prospect of dismal investment returns in equities is an outcome that is largely baked-in-the-cake. The only question is how much worse the outcomes will be as a result of Fed policy that has few economic mechanisms other than to encourage speculative behavior.

And of course this speculative behavior ends with only one feature - bubble risk...

A discussion of bubble risk would be incomplete without defining the term itself. From an economist’s point of view, a bubble is defined in terms of differential equations and a violation of “transversality.” In simpler language, a bubble is a speculative advance where prices rise on the expectation of future advances and become largely detached from properly discounted fundamentals. Put another way, a bubble reflects a widening gap between the increasingly extrapolative expectations of market participants and the prospective returns that can be estimated through present-value relationships linking prices and likely cash flows.


As economist Didier Sornette observed in Why Markets Crash, numerous bubbles in securities and other asset markets can be shown to follow a “log periodic” pattern where the general advance becomes increasingly steep, while corrections become both increasingly frequent and gradually shallower. I’ve described this dynamic in terms of investor behavior that reflects increasingly immediate impulses to buy the dip.




Along with this pattern, which has emerged with striking fidelity since 2010, we observe a variety of other features typically associated with dangerous extremes:

  • unusually rich valuations on a wide variety of metrics that actually have a reliable correlation with subsequent market returns; margin debt at the highest level in history and representing 2.2% of GDP (eclipsed only briefly at the 2000 and 2007 market extremes);
  • a blistering pace of initial public offerings - back to volumes last seen at the 2000 peak - featuring “shooters” that double on the first day of issue;
  • confidence in the narrative that “this time is different” (in this case, the presumption of a fail-safe speculative backstop or “put option” from the Federal Reserve); lopsided bullish sentiment as the number of bearish advisors has plunged to just 15% and bulls rush to one side of the boat;
  • record issuance of covenant-lite debt in the leveraged loan market (which is now spreading to Europe);
  • and a well-defined syndrome of “overvalued, overbought, overbullish, rising-yield” conditions that has appeared exclusively at speculative market peaks – including (exhaustively) 1929, 1972, 1987, 2000, 2007, 2011 (before a market loss of nearly 20% that was truncated by investor faith in a new round of monetary easing), and at three points in 2013: February, May, and today (see A Textbook Pre-Crash Bubble).

Many of us in the financial world know these to be classic features of speculative peaks, but there is career risk in responding to them, so even those who view the situation with revulsion can't seem to tear themselves away.



While I have no belief that markets follow any mathematical trajectory, the log-periodic pattern is interesting because it coincides with a kind of “signature” of increasing speculative urgency, seen in other market bubbles across history. The chart above spans the period from 2010 to the present. What’s equally unsettling is that this speculative behavior is beginning to appear “fractal” – that is, self-similar at diminishing time-scales. The chart below spans from April 2013 to the present. On this shorter time-scale, Sornette’s “finite time singularity” pulls a bit closer – to December 2013 rather than January 2014, but the fidelity to this pattern is almost creepy. The point of this exercise is emphatically not to lay out an explicit time path for prices, but rather to demonstrate the pattern of increasingly urgent speculation – the willingness to aggressively buy every dip in prices – that the Federal Reserve has provoked.

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boomer888's picture

Hussman may be the last bear that needs to capitulate before this market turns

DoChenRollingBearing's picture

Stocks keep going up, I will just sell some more.  But, I will be running out soon...

Meanwhile, in BitcoinistanTM:

"Fun with Bitcoin for Beginners: Part Two"


FinalCollapse's picture

The goatfuckers at the Fed neither care nor understand it.

Just one quick look at Mr. Yellen - she looks like a single-digit IQ moron.

Squid-puppets a-go-go's picture

The reason the  Fed does not see an “obvious” stock market bubble is because they snapped off the rear-view mirror and threw it out the window

Popo's picture

From the Hussman funds website:

Hussman Funds Performance Summary:

  • 1 Year -6.33%
  • 3 Year -7.40%
  • 5 Year -4.81%



GetZeeGold's picture



Because low employment participation rates are super uber bullish?

markmotive's picture

Has it ever been the Fed's job to watch for bubbles? Their mission is price stability and employment.

That's what makes it so easy to do this.

Marc Faber: The World is a Gigantic Asset Bubble


draghithebearslayer's picture

Hussman called market top back in March, 2012! (http://www.businessinsider.com/hussman-the-market-is-now-exactly-like-th...)

This explains why his fund logged -12% last year alone.

Timing the market is impossible.

Jim Quinn's picture

Full market cycle performance


This cycle isn't complete yet.


fonzannoon's picture

This is not a cycle. It's not a bull market either. It'sthe greatest behavioral finance experiment in history.

lewy14's picture

We are all lab rats now.

Honey Badger's picture

The question isn't whether there is a bubble or not, the question is when does it pop.

Cognitive Dissonance's picture

Can't see what you ain't looking for......or are paid to ignore.

Downtoolong's picture

Exactly. Want to see a bubble, just look at the Fed Balance Sheet. Sometimes the enemy is within.

asteroids's picture

The FED ain't that smart, they talk to people that lie to them. They believe every lie and build their models. The models eventually fail, panic, FED prints. Not being smart, they go back to the boyz and talk to them. The cycle repeats. The FED isn't blind, just stupid.

Squid-puppets a-go-go's picture

dude, wrong wrong wrong. dont let them off the hook by coming in on the generous side of the 'evil or incompetant' dilemma.

the Fed's major shareholders are the primary dealer banks. they know precisely how the wealth they deny the 'economy' is wealth that bolsters its owners

disabledvet's picture

exactly. "the Mission Accomplished sign has just been moved to the Marriner S. Eccles Building." Their bubble..."our problem." We're getting a new Chairman in a couple of months as well. Hmmm. Change in policy? Yeah, right. You wanna know who's in charge of your economy right now America? http://www.youtube.com/watch?v=a0wHzKzZ5rM "Star Voyager"...that's who.

ebworthen's picture

Debt?  Bubble in equities?  Unfunded liabilities?

This is America!  Those things don't exist here!

How dare you suggest such a thing!?!?

Now, when is lunch?

ak_khanna's picture

The central bankers and the politicians around the world are nothing more than auction items which can be sold to the highest bidder. They will do whatever they can for the lobbyist paying them the maximum amount of money or votes, be it the unions, the banksters, the richest corporations or individuals. They are in the power seat to extract maximum advantage for themselves in the small time frame they occupy the seat of power.

The rest of the population is least of their concerns. The only activity they do is pacify the majority of the population using false statistics and promises of a better future so that they do not lynch them and their masters while they are robbing the taxpayers.


disabledvet's picture

"whatdaya mean you don't want to publish the best you've got?"

socalbeach's picture

Dr Hussman is a smart guy, but naive.

"You’ve emphasized the tremendous burden placed on the Fed in recent years, and your dedication to collectively doing right by the country. It’s important to start with that recognition, because as concerned as I’ve been about the impact and economic assumptions behind the Fed’s actions, I don’t question your motives or integrity..."

Tinky's picture

You may be wrong, as Hussman's phrasing is more likely to reflect a sensitivity to how his warnings might be received, rather than naiveté.

Whom do you imagine that those in power are more likely to listen to, those who correctly but crudely call them out, or those who adopt Hussman's tone?

Even if one argues that making suggestions to sociopaths is futile, there is little point to the exercise if the tone of the message guarantees that it will be ignored.

socalbeach's picture


However, I've noticed that in general he seems to take things at face value, as in:

"it wasn’t the sort of outlier that would justify the suggestions of political conspiracy that were bandied about over the weekend..." (October 8, 2012)

"As it happens, much to the chagrin of conspiracy theorists, we would expect the present cycle to peak out roughly the week of the election..." (November 5, 2012)

"Conspiracy theorists take note – the recent round of “surprises” follows the fairly regular pattern that we’ve observed in recent years..." (October 22, 2012)

disabledvet's picture

"mind martian. yeah. i like the sound of that."

lailapa's picture

World War III - The first private war in history

Those who won all battles shall lose the war



“Commander of chief” for the battlefield was Jew Greenspan, leader of the “gun" named Federal Reserve Bank of USA. "General" was Jew Wolfensohn of the World Bank. "General" was Jew Trichet of the European Central Bank. "General" was Jew Ackermann of the Deutsche Bank. They cooperated and they leveled everything.


Trimmed Hedge's picture

Taylor, just go buy some Washington Mutual and take that yield...


EDIT: Or just buy some bitcoin and have it quadruple in value in less than 30 days...

Seal's picture

did anyone show this to 

Hugh Hendry?
new game's picture

really, really thinking we all are fucked. in this mess and nowhere to hide assets.

I mean, anyone? gold-questionable, farmland or land, home paid for(shelter defendable), some food and water and carry on like all fine til time to pull off the sheepskin and bare the teeth in self defense. carry on, some ignorance will carry you thru. ah da say what...

Wahooo's picture

Hussman is so rational. But when has the market ever been rational?

Dr. Venkman's picture

Hussman presupposes that the Schiller PE log chart suggests that a crash is imminent in Jan 2014. At this rate of lunacy, what is stopping it from just going geometric and shooting to the moon (on Jupiter?) double QE in Dec 13' SandP 2200 by Feb 2014.

FinalCollapse's picture

Exactly - there is no market. The pricing mechanism was destroyed long time ago. What we have instead are idiots behind the steering wheel, pushing the accelerator to the floor, while drinking booze. 

augustusgloop's picture

Log periodic oscillation seems to be decent predictor of bubbles. In an case, I trust math more than I do pundits. Here is a link to some "crazy Ivans" that predicted the gold bubble to pop in may-june 2011 with the same patterns. Off by just a few months: 


ebworthen's picture

What?  No Immelman's?

Pop bubble, pop!

Kreditanstalt's picture

Who needs all this math, equations and algorithms???

The "markets" are comprehensively valued in outer space.

Just look outside your window at all the "for lease" signs and failing small businesses amid the fat and sassy well-paid government and state-protected sector employees and then think of how many of your neighbours' kids can find good jobs...

ebworthen's picture

Shhh!  You're raining on the parade!  Bartiromo is going to FOX!

Hard nipples and S&P 2,500!!!

Squid-puppets a-go-go's picture

QE to infinity means that the bubble can continue to grow until every last final drop of capital has been destroyed.


andrewp111's picture

In english, this sentence

b) margin fluctuations are largely driven by cyclical variations in the combined savings of households and government,

means that Federal Deficits drive corporate profits. Since record deficits will be with us for a very long time, perhaps this is why the market isn't worried about mean reversion of profits. But they should be. Profits can be reduced dramatically by political risk, and there is a huge and growing pressure to double the minimum wage. 

dcohen's picture

That's it, Bernanke will destroy Hussman ASAP - NEXT!

Bernanke the Bear Nazi

lolmao500's picture


Chinese in Japan told to register for ‘emergencies’ amid territorial row

All good...

TheRideNeverEnds's picture

please keep telling me about an inflationary bubble in stocks.


meanwhile we are hitting new all time highs weekly if not daily on the markets and metals are tanking to multi year lows. 


face it we can print money FORVER with no consiquences, the only consequence is if we stop, so we wont; ever. 


when are you going to cover your shorts?  as we pass through 1850 in DEC to hit 1900 by the end of JAN?  As we pass 1900 in FEB on our way to close out the year up around 2500?


any dips are buys, the market wont be over bought for a while, somewhere around 5500 in the ES in two years and I will get short.


if you are short here you may as well just take your money and light it on fire, it will bring you more amusement and if you youtube it maybe you can make some of it back as opposed to losing it all fighting the fed.  





ebworthen's picture

You could be right, as the FED profligacy seems to have no end.

Problem being, it is the biggest CONfidence game in history.

If you take profits they will be taxed, if you don't you'll lose.

Poor folks in I.R.A.'s, 401K's, and Pension funds.

It's a bubble, just no knowing when it pops.

Lack of confidence will do it.

2000-2008 ended.

This will too.

Wahooo's picture

It's simpler than that. As long as the banks are back-stopped, there will be no collapse.

yrbmegr's picture

No, there will be no collapse.  If there is a disruption, it will be of a kind for which there is no word.

gosh's picture

i dont think the feds GIVE A SHIT.  they just care about the RICH not US

Iam Yue2's picture

This made me laugh;

Russell Napier | blogs.ft.com
30 Oct 2013 - There are a few still carrying the flame – Russell Napier, the stock market historian, still thinks the S&P 500 will fall to 500.

I've chaned my overall strategy, when zerohedge fav Napier finally capitulates; it will be time to go short.

Here's Napier from a year ago;

"Napier said of the graph: "It is the most important chart in the world. The growth in Chinese reserves has determined all the key developments in financial markets in the last two decades. It printed lots of currency and artificially depressed the US yield curve. It has been the cornerstone of global growth, and now it's over."

Just a pity nobody else noticed Russell.........? Maybe you should have just stuck to the analysis, rather than get sucked into the zerohedgian style big calls?

Did somebody say egg on face? Or in the case of Russell ...ulster fry on head, perhaps.

TwoJacks's picture

the real capitulation re: Hussman will come when his fund has to close from lack of investors' money. Those are the real bears over there. Hussman is just serving them and doing his own intellectual exercises in the process.

ebworthen's picture

The dysfunctional Parent is usually the last person to face the fact that their kid is an abjectly dependent drug addict.

p.s. - Mandlebrot is laughing at the FED from beyond the grave.

Doubleth1nker's picture

Now that we have a new Fed ChairThing (Man, Woman, who knows) who is both mentally ill and committed to staying that way, theh ain't no way fo this rigged casino to go but straight to da moon alice!  Sornette be damned! 

kw2012's picture

I will give you a trillion dollar Zimbabwian bill for your shares of Apple Stock.