Calm Before The Storm
From a cyclical perspective, the stock market has effectively gone nowhere since mid-2014 (with zero total return on the broad NYSE Composite since then). The past two years can be characterized less as an ongoing bull market than as the extended top-formation of the third speculative episode since 2000, the third most extreme equity market bubble in history (next to 1929 and 2000), and the most extreme point of overvaluation in history across the broad cross-section of individual stocks and asset classes.
We don’t expect the current situation to end well for investors who insist on taking larger investment exposures than they’re actually willing to hold, with discipline, through a period of severe market losses. From present valuation extremes, a 40-55% market loss would represent a fairly run-of-the-mill resolution to the current market cycle; a decline that would take valuations only to the high-end of the range they’ve visited or breached over the completion of every market cycle in history. By the completion of the current cycle, I expect over $10 trillion of what investors count as paper “wealth” in U.S. equities to disappear without a trace.
Fool me once, shame on you; Fool me twice, shame on me; Fool me a third time and it's pretty clear who the bloody idiot is...
Keep in mind that what investors count as “wealth” in financial assets doesn’t “go” somewhere else during a market decline. It simply vanishes. Market capitalization equals price times the number of shares outstanding. If even one share changes hands at a lower price, market capitalization falls by the change in price times the number of shares outstanding. If a dentist in Poughkeepsie sells a single share of Apple stock, at a price that’s just a dime lower than the previous price, over $500 million of paper “wealth” is instantly wiped out of U.S. stock market capitalization. Every security that’s issued has to be held by someone until that security is retired. It’s just that the owners change. The actual cumulative economic wealth embodied in a security is the stream of future cash flows it will deliver to its holders over time, and even that stream of cash flows counts as a liability of the issuer.
Both investors and policy makers would do well to understand that when one nets out all of the assets and liabilities in the economy, the only true wealth of a society consists of its stock of real private investment (e.g. housing, capital goods, factories), real public investment (e.g. infrastructure), intangible intellectual capital (e.g. education, inventions, organizational knowledge and systems), and its endowment of basic resources (e.g. land, energy, water). In an open economy, one would include net claims on foreigners (negative in the U.S. case).
So contrary to the idea that Fed-induced yield-seeking speculation has created “wealth,” the fact is that monetary policy has done little but to distort the financial markets and encourage repeated cycles of malinvestment and collapse. It’s misguided to imagine that the gap between the future consumption needs of an aging population and the future output of a productivity-challenged economy can be addressed by central banks through greater purchases of riskier assets or “helicopter drops" of spending power, as if speculation generates economic productivity, or as if fiscal policy is run by central banks rather than Congress. No. The only way to close the gap is through policies that encourage productive real investment at every level of the economy, rather than fostering pointless financial speculation. Every day that central banks hold out the false hope of a paper solution is a day that chips away at the productive foundations of our economy.
And Hussman concludes, once a market cycle is completed, everything seems obvious in hindsight. Soon enough, investors will wonder why they didn’t consider the extreme risks of the current environment to be just as obvious.
Here's how activist monetary policy works... (spoiler alert - it doesn't)