Excerpted from John Hussman's Weekly Market Comment,
There’s really no point in trying to convert anyone to our viewpoint. Somebody will have to hold stocks over the completion of the present cycle, and encouraging one investor to reduce risk simply means that someone else will have to bear it instead.
But for those who understand the narrative of the recent half-cycle, where our challenges have been, and how we’ve addressed them, I do encourage reviewing all risk exposures from the standpoint of the losses that have repeatedly occurred over the completion of market cycles that have reached valuations anywhere near current levels (1929, 1972, 1987, 2000, and 2007). The point is not to discourage stock holdings entirely, but rather to ensure that exposure is not so large that a steep market loss would be intolerable. It’s important to recognize that the market is not only at a point where unusually rich valuations are already in place, but also where market internals and our measures of trend uniformity have clearly deteriorated. This is the most hostile set of market conditions we identify, and it closely overlaps periods in which the stock market has been vulnerable to abrupt air-pockets, free-falls, and crashes.
As I did in 2000 and 2007, I feel obligated to state an expectation that only seems like a bizarre assertion because the financial memory is just as short as the popular understanding of valuation is superficial: I view the stock market as likely to lose more than half of its value from its recent high to its ultimate low in this market cycle.
At present, however, market conditions couple valuations that are more than double pre-bubble norms (on historically reliable measures) with clear deterioration in market internals and our measures of trend uniformity. None of these factors provide support for the market here. In my view, speculators are dancing without a floor.
A final note: There is a danger in ignoring the concerns of value-conscious investors as a bubble proceeds. The danger is that the longer these concerns are “proven wrong” by further advances, the more severely they are likely to be proven correct by an even deeper loss over the completion of the cycle. Roger Babson offers a useful lesson in that regard. Babson, whose first rule of investing was to “keep speculation and investments separate,” is known not only for founding Babson College in Massachusetts, but also for a speech at the National Business Conference on September 5, 1929, at the peak of the market, saying “sooner or later a crash is coming, and it may be terrific.”
The back-story, however, is that Babson’s presentation began as follows: “I’m about to repeat what I said at this time last year, and the year before…” The fact is that Babson had been “proven wrong” by an advance that had taken stocks relentlessly higher during the preceding years. Over the next 10 weeks, all of those market gains would be erased. From the low of the 1929 plunge, the stock market would then lose an additional 75% of its value by its eventual bottom in 1932 because of add-on policy errors that resulted in the Great Depression. As a side note, those policy errors were not that banks were allowed to fail, but that policy makers allowed them to fail in a disorganized way, forcing loans to be called in rather than taking banks into receivership and restructuring existing debt. It's a distinction our own policy makers still haven't learned, and simply obscured and papered over in the 2008-2009 crisis through distortionary monetary policy, bailouts, and FASB accounting changes. As a consequence, the debt overhang is still very much intact, as the Center for Economic Policy Research recently warned in its 16th annual Geneva Report. But that's now a problem for another day.
In any event, be careful in believing that a market advance “proves” concerns about valuations wrong.
What further advances actually do is simply extend the scope of the potential losses that are likely to follow. That lesson has been repeated across history. The chart above offers a visual of this story, and may serve as a useful reminder that valuation concerns are generally not durably proven wrong by further advances, particularly when market valuation concerns have been ignored for a long while.