John Hussman's Formula For Market Extremes

Tyler Durden's picture

Market extremes generally share a common formula. One part reality is blended with one part misguided perception (typically extrapolating recent trends as if they are driven by some reliable and permanent mechanism), and often one part pure delusion (typically in the form of a colorful hallucination with elves, gnomes and dancing mushrooms all singing in harmony that reliable valuation measures no longer matter). This time is not different.


Via John Hussman's Weekly Market Comment,

The technology bubble was grounded in legitimate realities including the emergence of the internet and a Great Moderation of stable GDP growth and contained inflation. But it also created a misperception that it was possible for an industry to achieve profits while having zero barriers to entry at the same time (the end of that misperception is why the dot-com bubble collapsed), a misperception that technology earnings would grow exponentially and were not cyclical (as we correctly argued in 2000 they would shortly prove to be), and the outright delusion that historically reliable valuation measures were no longer informative. Meanwhile, the same valuation measures we use today were projecting – in real time – negative 10-year nominal total returns for the S&P 500 over the coming decade, even under optimistic assumptions (see our August 2000 research letter).

The housing bubble was grounded in legitimate realities including a boom in residential housing construction and a legitimate economic recovery that followed the 2000-2002 bear market (which we responded to by shifting to a constructive stance in April 2003 despite valuations still being elevated on a historical basis). But the housing bubble also created a misperception that mortgage-backed securities were safe because housing prices had, at least to that point, never experienced a major collapse. The delusion was that housing was a sound investment at any price. The same delusion spread to the equity markets, helped by Fed-induced yield-seeking speculation by investors who were starved for safe return. Meanwhile, the same equity valuation measures we use today helped us to correctly warn investors of oncoming financial risks at the 2007 peak (see A Who’s Who of Awful Times to Invest).

The 2008 credit crisis, which we anticipated, was more challenging for us because the extent of employment losses and gravity of asset price collapse was greater than we had observed in the post-war data that underpinned our methods of assessing the market return/risk profile. Our valuation methods didn’t miss a beat, and correctly identified a shift to undervaluation after the late-2008 market plunge (see Why Warren Buffett is Right and Why Nobody Cares). But examining similar periods outside of post-war data, we found that measures of market action that were quite reliable in post-war data were heavily whipsawed in the Depression, and even the valuations we observed at the 2009 market lows were followed, in the Depression, by an additional loss of two-thirds of the market’s value. My resulting insistence on ensuring our methods were robust to that “two data sets” problem was necessary, but the timing could hardly have been worse, with an initial miss in the interim of that stress-testing, and an awkward transition to our present methods of classifying return/risk profiles.

The present market environment is grounded in the legitimate reality that the labor market has recovered its losses, but not to the extent that creates resource constraints or clear interest rate pressures. Though broad measures of economic activity have actually eased to year-over-year levels slightly below those that have historically distinguished expansions from recessions, the economy seems to be treading water, and don’t observe a particularly negative tone. Still, the recent period has created a misperception that monetary easing itself will support financial markets regardless of their valuation. The error here is that we know from history that it does not. Indeed, the 2000-2002 and 2007-2009 collapses both progressed in an environment of aggressive and sustained monetary easing. What’s actually true about monetary policy is that zero-interest rate policy has created a perception that investors have no alternative but to “reach for yield” in riskier assets. It’s entirely that reach for yield that investors must rely on continuing indefinitely, because there’s no mechanistic cause-effect relationship between the Fed balance sheet and stock prices, bank lending, or economic activity.

As usual, the delusion is that this Fed-induced reach for yield is enough to make equities a sound investment at any price. Ironically, the Fed itself is in the process of reversing course on this policy. Meanwhile, based on the same valuation methods that correctly projected negative 10-year returns at the 2000 peak, correctly gave us room to shift to a constructive position in early 2003, correctly helped us warn of severe market losses at the 2007 peak, and correctly identified the shift to market undervaluation in late-2008 (which those who don’t understand our stress-testing narrative may not recognize), we currently estimate prospective S&P 500 nominal total returns of just 2% annually over the coming decade, and negative returns on every horizon shorter than about 7 years.

In short, investors who are reaching for yield in stocks as an alternative to risk-free assets are most likely reaching for a negative total return in stocks between now and about 2021.

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So Close's picture

It is different this time.

OpenThePodBayDoorHAL's picture

Only thing that matters is what the CBs do. Do they behave like a real investor would? Do they ever sell? Maybe not, $29 trillion in dumb money that will never budge, an "unlimited" printing press without end. Think I'm gonna go buy some calls...

economics9698's picture

Mr. Hussman I read your blog on a regular basis.  We do not care if you got it right in 2003, 2007, or 1993.  Just give the reader what you know and why you know it.  You have the PhD, which speaks for itself.  We know you can do integrals and differential equations.  Stick with the facts as you interpret them and stop the self-promotion.

LawsofPhysics's picture

Blah blah blah, ignore what successful people say, pay attention to what they do...

Full faith and credit"

tick tock motherfuckers...

AccreditedEYE's picture

this dude has been beating the same drum for over 5 years now. Get a clue man... rigged games don't follow any rules. Nothing is going to collapse till Yellen says so and markets are moving higher.

LawsofPhysics's picture

Correct.  Those in "the club" will know how the rules will change long before they do.

Only a genuine shooting/killing world war would change anything substantial and even then the "club members" around the world would still be briefed well in advance.

same as it ever was...

economics9698's picture

Schiff was off in his timing, doesn't mean he wasn't right.

disabledvet's picture

"equity for debt" swap.

crushing demand and laying the groundwork for further defaults.

that's all 2008 was.
move along.

here's a song:

assistedliving's picture

too true aye aye.  u know ur in trouble when everything in your portfolio u love least is up most, everything ur sure is right is down big (shorts) and uv underperformed the S&P by 30% or more for five frickin years.

Spungo's picture

He might be right on macro, but he sure sucks at stock picking. Check his mutual funds on google finance.

max2205's picture

Over half of my 150 watch list are off mlre than 20%


Look out if they all turn around

BuddyEffed's picture

"is grounded in the legitimate reality that the labor market has recovered its losses, but not to the extent that creates resource constraints "

The above is the straw man in this article, and many would disagree with its premise.

rosiescenario's picture

"The present market environment is grounded in the legitimate reality that the labor market has recovered its losses..."


I have a problem with this statement. Is he actually saying that employment has recovered? We've lost higher paying jobs and have created a lot of low paying ones. To my mind that is not a recovery.

Spungo's picture

"You have the PhD, which speaks for itself. We know you can do integrals and differential equations."

Watch his presentations on youtube. His analysis is interesting. What he does is look for correlations between things and stock returns. One of them was combining the Shiller PE with corporate profit margins to predict future stock returns. It's all statistics, so 99% of people don't understand what Hussman is saying. I don't know why, but people are horrible with statistics. Saying returns will average 2% yearly over the next 10 years DOES NOT mean it will go up 2% every year for the next 10 years. It's an average. If you buy right now, it might go up 10% this year, then crash 60% after that, then go up 30% the next year, etc. When all of the 10 years are added up, the end result is about 2% per year. It would be like if you had bought stocks at the peak in 2006-2007 and just now are breaking even again. The past few years have seen 20-30% gains, but your averaged performance from 2007 to now might only be 1% per year.

This doesn't excuse his lousy stock picking. If you check his global growth fund on google finance, you'll see most of his portfolio is stock options. I think that's a dangerous strategy because options have time premium decay. He's trying to time the market with way too much precision. Hussman is a smart guy, but I disagree with his way of betting against the market. Schiff is betting against the market by buying gold, oil, and other natural resources that do well during inflation. Doug Casey is placing his bets on cattle, which is a weird investment, but food generally does very well during inflation. Jim Rogers said he was big on agriculture, which is another good inflation hedge. I'm betting against the market by buying and selling mining stocks based on bollinger bands, which is almost as dangerous as what Hussman is doing, but at least I don't have time premium decay. The more adventurous people are betting against the market by shorting worthless stocks that have no earnings.

what's that smell's picture

"my favorite number is 5. i'm thinking of a number between 1 and 10. what is it?"



DOGGONE's picture

IF youse guys would show the truth
you would much better use the readers' time.