"This Is Where They Completely Lost Their Minds” - Hussman

"This Is Where They Completely Lost Their Minds” - Hussman

- Hussman warns 'the S&P 500 to lose approximately two-thirds of its value over the completion of this cycle'
- 'the market has lost value, even since 2009, when overvalued, overbought, overbullish conditions were joined by divergent internals'
- Believes the market is going to learn lessons about the crash 'the hard way'

 

 

In an almost prophetic blog post from John Hussman last week, we are warned about the bubble waiting to collapse in the US equity market and the hard lesson investors are about to learn.

Drawing on both his own experience and the work of the much revered Didier Sornette, Hussman looks at the current state of the US equity market, where it sits in its cycle and how it compares to history.

The prognosis is not good. Hussman warns that " the market has lost value, even since 2009, when overvalued, overbought, overbullish conditions were joined by divergent internals...I expect the S&P 500 to lose approximately two-thirds of its value over the completion of this cycle."

Of course, the lesson may have finally begun. On Monday February 5th the Dow Jones dropped over 1,000 points, the largest single day drop ever, on a points-basis. Meanwhile, also on the 5th,  the S&P500 went negative for 2018 closing down more than 7 percent from a record set in January. Similar action was repeated on the 8th February, with many traders declaring they'd never seen anything like it.

Gold performed well following the rout and we believe gold prices may rise further as the drama leads period of risk aversion and a new found appreciation by investors looking for gold’s hedging and safe haven attributes.

You can hear more about our bubble crash predictions in our Goldnomics podcast. Here we take a look at one of the important financial questions of our day – is this the greatest stock market bubble in history?

 

Excerpts taken from 'Measuring the Bubble' on 1st February 2018

Last week, the U.S. equity market climbed to the steepest valuation level in history, based on the valuation measures most highly correlated with actual subsequent S&P 500 10-12 year total returns, across a century of market cycles

As Didier Sornette correctly observed in Why Markets Crash,

“The collapse is fundamentally due to the unstable position; the instantaneous cause of the crash is secondary.”

My sense is that investors are going to learn this again the hard way.

On the accelerating slope of the current advance

Speaking of Didier Sornette, I’ve periodically discussed his concept of “log periodic power-law” price behavior, which has accompanied speculative episodes in numerous markets and often precedes inflection points or collapses. This structure is based on a purely mathematical fit to price behavior, and does not reflect any valuation considerations. It’s not part of our own investment discipline, but we occasionally fit the log-periodic structure to price behavior when market movements are particularly extreme.

In recent years, those structures have generally identified inflection points of flat or correcting prices, but certainly not crashes in the S&P 500. Given the increasingly steep slope of the current market advance, along with the most extreme valuations in history and the most lopsided bullish sentiment in more than three decades, it’s quite possible that this instance will be different. In any event, the underlying “arbitrage” considerations described by Sornette are worth reviewing here.

In 2000, as the tech bubble was peaking, Nobel laureate Franco Modigliani observed that the late stages of a bubble can be “rational” in a certain sense, provided that investors are inclined to self-reinforcing behavior.

Imagine a market that you fully believe to be overvalued and at risk of a market crash. Indeed, let’s say that there is a defined probability of a crash, which increases rapidly as the pitch of the market advance becomes more extreme. Should you sell? Well, it depends. Given that an immediate crash is not certain, a speculator must, in each period, weigh the potential gain from holding a bit longer against the potential loss from overstaying. Sornette uses a similar argument to describe a speculative bubble advancing toward its peak (italics mine):

“Since the crash is not a certain deterministic outcome of the bubble, it remains rational for investors to remain in the market provided they are compensated by a higher rate of growth of the bubble for taking the risk of a crash, because there is a finite probability of ‘landing smoothly,’ that is, of attaining the end of the bubble without crash.”

“This line of reasoning provides us with the following important result: the market return from today to tomorrow is proportional to the crash hazard rate. In essence, investors must be compensated by a higher return in order to be induced to hold an asset that might crash. As the price variation speeds up, the no-arbitrage conditions, together with rational expectations, then imply that there must be an underlying risk, not yet revealed in the price dynamics, which justifies this apparent free ride and free lunch. The fundamental logic here is that the no-arbitrage condition, together with rational expectations, automatically implies a dramatic increase of a risk looming ahead each time the price appreciates significantly, such as in a speculative frenzy or in a bubble. This is the conclusion that rational traders will reach.”

 

The chart below shows our current best-fit parameterization of Sornette’s log-periodic structure, applied to the S&P 500 Index. Notably, unless we allow for the slope of the current market advance to become quite literally infinite, it’s impossible to closely fit the current price advance without setting the “finite-time singularity” – the point at which instability typically emerges – within a few days of the present date. Notably, the singularity is not the date of a crash. Rather, it’s the point where the pitch of the advance reaches an extreme, which may simply be an inflection point (as has been the case for other structures in recent years) or a pre-crash peak.

The collapse is fundamentally due to the unstable position; the instantaneous cause of the crash is secondary.
– Didier Sornette

If you want my opinion (which we don’t trade on and neither should you), my opinion is that this singularity will prove to be more than an inflection point.

Though nearly every morning prompts the phrase “Yup, they’re actually going to do this again,” the steepening pitch of this ascent – coupled with record valuation extremes, record overbought extremes, and the most lopsided bullish sentiment in over three decades – now produces the most extreme “overvalued, overbought, overbullish” moment in history. In prior cycles across history, similar syndromes were either joined or quickly followed by deterioration in market internals. In this cycle, it has been essential to wait for explicit deterioration in market internals before establishing a negative outlook. Notably, the market has lost value, even since 2009, when overvalued, overbought, overbullish conditions were joined by divergent internals.

I expect the S&P 500 to lose approximately two-thirds of its value over the completion of this cycle.

My impression is that future generations will look back on this moment and say “… and this is where they completely lost their minds.”

As I’ve regularly noted in recent months, our immediate outlook is essentially flat neutral for practical purposes, though we’re partial to a layer of tail-risk hedges, such as out-of-the-money index put options, given that a market decline on the order of even 5% would almost certainly be sufficient to send our measures of market internals into a negative condition. It’s best not to rely on the ability to execute sales into a falling market, because the range-expansion we’ve recently seen on the upside may very well have a mirror-image on the downside. As usual, we’ll respond to new evidence as it emerges.

Comments

Catullus Sat, 02/10/2018 - 13:38 Permalink

The greatest bull market in history was from 1949-1969. 150 to ~700 on the S&P. With 3-4 25% pullbacks along the way that lasted an average of 4 months.

There's also the possibility that this bull market lasts another 10 years albeit only a 50% upside remains. And it took bond yields going to 18% for that equity bull market to crash.

You could still see 4500 on the S&P by 2026

Element Catullus Sat, 02/10/2018 - 20:52 Permalink

 

 

One of the more prescient remarks Hussman has been making in the past few months is the tendency for the speculatively frenzied mindset, to fail to recognise the synergistic effects of its own speculation on the resulting market valuations, but instead wants to presume that some other deep integral factor must be responsible for the rising valuation levels, the miracle of the grassy uplands, which they keep seeing, and which keeps them speculating all the more.

 

"This could go on ... and on ... and on ...", and then it doesn't.

 

Hence the classic tendency to sharp rises and even sharper falls near the top of the cycle.

 

Same occurred in China in 2015/2016, but almost no one ever seems to remember this, it's always "different this time".

 

And never is.

 

And you're currently thinking that it just ain't so ... this time around ... this could go on ... and on ...

In reply to by Catullus

checkessential Element Sun, 02/11/2018 - 10:31 Permalink

It's ALWAYS different this time.  The mistake is assuming that because today's details are different than yesterday's, something different will happen.  History has been repeating itself for thousands of years and every repeat is surrounded by different circumstances.  

In reply to by Element

lucyvp Sat, 02/10/2018 - 16:14 Permalink

Dr Hussman, has taught me much both explicitly with his beautiful market commentary, and implicitly, by losing money in his fund year in and year out, waiting for Godot.

He is right about the market, but like most prognosticators his timing is not so good.

The market is far over valued on a fundamental basis.  The only thing that can maintain the current price structure is money printing and dollar devaluation.  Look at Amazon as an example.  PE is 220,  Is Amazon going to become 10 times larger, or 10 times more profitable so the PE decreases to a number where I can get my money back within my remaining life time?  don't think so.

Instead of PE ratio we should have PLB ratio which is price / loaves of bread.  Money printing will result in higher prices, but a constant or declining PLB ratio.

On a different note, note that the carrying cost of federal debt has switched from negative since the financial crisis to positive just recently.   Figure in drunken sailor spending, deficit financed tax cuts, aging demographics, rising interest rates, and a carry cost hockey stick is fast approaching.  Hug your children, I think we are now accelerating toward the fiscal cliff.

 

 

 

 

Cesare de Borgia Sun, 02/11/2018 - 05:54 Permalink

This is how I feel right now 

Picture yourself in a fancy casino where the walls are starting to show cracks and seems. 

But your money is still on the roulette table and the ball just keeps spinning. 

Meanwhile the ceiling is falling down. 

Do you cut your loses and run leaving all the money behind or do you wait until it hits 31 and you can be rich but risk having the lamps fall on your head?