'My comments approaching the 2007 market peak and the global financial crisis provide an appropriate end to this discussion, and offer a sense of the kind of market action that would amplify our immediate concerns.''The truth is that when investors become willing to accept elevated market valuations and high stock prices, they are typically accepting very low risk premiums and future returns as compensation for accepting risk.
Conversely, when investors become fearful of depressed valuations and low stock prices, they are typically demanding very high risk premiums and future returns as compensation for accepting risk.
A market crash is nothing more than a period where low risk premiums are pushed abruptly higher. For that reason, the combination of thin risk premiums, increasing risk-aversion, and upward yield pressures is the single most negative set of conditions an investor can face. Ignore this paragraph to your detriment.
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The key point is that strong investment opportunities are almost always born out of discomfort. Likewise, market collapses are almost always born out of confidence and euphoria.
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For now, investors should not rule out the potential for steep market losses. In the context of a market that would have to decline by about two-thirds to just to reach
run-of-the-mill historical norms on reliable valuation measures, the losses we observed in February and March were next-to-nothing.
It’s worth emphasizing again that if interest rates are low because growth rates are also low (as we presently observe), no valuation premium is “justified” by the low interest rates at all. To the contrary, even historically normal valuation multiples would be associated with below-average expected future returns, by virtue of the lower growth rate. See my prior market comments of recent months for extensive evidence on this point.
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While a clear break of the February market lows could provoke a concerted attempt by trend-following investors to exit the market (with little interest from value-conscious investors at those levels), we already observe the same combination of extreme valuations and divergent market internals that we observed at the 2000 and 2007 peaks. We always have to allow for a shift in the behavior of market internals, so the fact that they’re unfavorable here doesn’t necessarily imply that the full cycle has shifted from bull market to bear market. Still, nothing we observe – including the behavior of earnings, employment, or the economy – is inconsistent with that possibility.
It’s a very dangerous thing when analysts on financial television say “you can’t have a bear market here because X is still true.” Those statements are even more dangerous when they are inconsistent with historical data. Last week, I heard an analyst say that bear markets don’t start when earnings are still growing. That’s not true at all. It’s after prices are already collapsing that earnings growth suddenly drops like a rock.
For our part, we’re tightly focused on the uniformity and divergence of market action across a broad range of securities. That internal market action deteriorated further last month, despite fairly sideways movement in the major indices. We would pay particular attention to credit spreads here (the difference in yields between riskier corporate debt and Treasury securities), particularly any increases in corporate yields that are accompanied by flat or declining Treasury bond yields.
In the equity markets, be alert about the potential for coordinated selling should February’s lows be taken out. We’d also monitor European bank stocks, and any tendency for stocks to become highly volatile over progressively short intervals.
My comments approaching the 2007 market peak and the global financial crisis provide an appropriate end to this discussion, and offer a sense of the kind of market action that would amplify our immediate concerns.
<blockquote>“One of the best indications of the speculative willingness of investors is the ‘uniformity’ of positive market action across a broad range of internals… I’ve noted over the years that substantial market declines are often preceded by a combination of internal dispersion, where the market simultaneously registers a relatively large number of new highs and new lows among individual stocks, and a leadership reversal, where the statistics shift from a majority of new highs to a majority of new lows within a small number of trading sessions.
“This is much like what happens when a substance goes through a ‘phase transition,’ for example, from a gas to a liquid or vice versa. Portions of the material begin to act distinctly, as if the particles are choosing between the two phases, and as the transition approaches its ‘critical point,’ you start to observe larger clusters as one phase takes precedence and the particles that have ‘made a choice’ affect their neighbors. You also observe fast oscillations between order and disorder in the remaining particles. So a phase transition features internal dispersion followed by leadership reversal. My impression is that this analogy also extends to the market’s tendency to experience increasing volatility at 5-10 minute intervals prior to major declines.”
– John P. Hussman, Ph.D., Market Internals Go Negative, July 30, 2007</blockquote>
- John P. Hussman, Ph.D.,
Comfort is Not Your Friend, May 8, 2018
Context'..the higher the level of debt the greater the restraint on economic growth.''..the next financial tremors will come from corporate debt.''..the risks that non-bank investors (and some banks) face in the leveraged loan world.' - Gillian Tett'..three decades of recurring boom and bust cycles..' - Doug Noland