'I describe recent Fed policies with the word “deranged” intentionally – not just because those policies took interest rates and the monetary base far outside of their historical range, but also because doing so has encouraged an even more grotesque round of yield-seeking speculation than the preceding mortgage bubble, which ended in global financial collapse. In the interest of protecting the jobs of bank executives, and protecting bank bondholders from perhaps a few hundred billion dollars in losses (depositors were never at risk, which should be immediately obvious from studying any bank balance sheet), the Fed created yet another yield-seeking bubble that has encouraged vastly expanded indebtedness in every sector of the economy, and has set U.S. equity market investors up for a likely loss in excess of $20 trillion in market capitalization in the coming years.''Presently, the dispersion we observe in market internals suggests that investors are becoming increasingly selective; that their psychology has subtly shifted away from speculation, and toward risk-aversion. Our own measures shifted negative on February 2, 2018. More recently, the 2% advance of the S&P 500 Index beyond its late-January high has been accompanied by a sharp narrowing of participation and leadership across individual securities. The profound narrowing we observe in daily data, coupled with repeated leadership reversals within a fraction of a percent of the recent market highs, is what amplifies the likelihood that recent valuation extremes will have immediate and severe consequences, as they did after the 2000 and 2007 peaks.
Among the features we observe at a daily resolution, the advance to the most recent record high on Thursday, September 20 was accompanied by a string of trading sessions with elevated totals of both new 52-week highs and new lows on the NYSE, followed by an immediate leadership reversal where the number of new lows soared above the number of new highs, despite the fact that the S&P 500 was still within a fraction of a percent of its record. Similarly, participation has been ragged, with over 40% of NYSE issues already below their respective 200-day moving averages even as the S&P 500 has pushed higher. We observed a similar combination of internal divergences, leadership reversal, and ragged participation immediately surrounding the 2007, 2000, 1987 and 1973 market peaks. The music is fading out, and a trap-door has opened up in the floor, but they’re still dancing.
..
..Ben Bernanke’s deranged monetary experiment with quantitative easing, unleashed a perfect storm, and investment outcomes that were nothing like our admirable experience in previous complete market cycles.
As investors became convinced that zero interest rates gave them no alternative but to speculate, it became utterly detrimental take a pre-emptive bearish stance in response to “overvalued, overbought, overbullish” extremes, as one could have done in previous market cycles. The solution to this problem seems obvious in hindsight, but reaching it was painfully incremental because a century of evidence encouraged an immediate bearish response to those extremes.
Put simply, in late-2017, we abandoned the idea that there is any definable “limit” to speculative recklessness of Wall Street, as there was in prior market cycles. We now require explicit deterioration in market internals in order to adopt a bearish market outlook, with no exceptions. We can hold a neutral outlook given sufficiently extreme conditions, but whenever uniformly favorable market internals indicate that the speculative bit is back in their teeth, our willingness to adopt or amplify a negative market outlook drops to zero. Most often, when our measures of market internals are uniformly favorable, our market outlook will be constructive as well.
The fact is that valuations and market internals, in combination, navigated the recent market cycle beautifully, as they have in prior market cycles. Indeed, the entire net gain in the S&P 500 in the complete cycle from the 2007 peak to the present has occurred in periods where our measures of market internals were favorable. In contrast, nearly all of the 2007-2009 market collapse occurred in periods when those measures were unfavorable.
Likewise, our measures of valuation correctly identified extremes in 2007 and today, and identified the market as undervalued in late-2008 and 2009, which I
observed in real-time. It’s a profound mistake to imagine that valuations or market internals have become less effective in navigating market cycles. There’s no evidence to that effect.
..
A $20 trillion loss in market capitalizationOn the subject of Federal Reserve policy, the current back-slapping about the success of extraordinary monetary policy is a lot like declaring victory in a football game at halftime, just before a flock of fire-breathing dragons swoops onto the field and eats the leading team. As we saw in the collapse of the mortgage bubble (another product of yield-seeking speculation brought to you by your friends at the Federal Reserve), we have to allow for the possibility that the second half of the game will be violently unrecognizable.
I describe recent Fed policies with the word “deranged” intentionally – not just because those policies took interest rates and the monetary base far outside of their historical range, but also because doing so has encouraged an even more grotesque round of yield-seeking speculation than the preceding mortgage bubble, which ended in global financial collapse. In the interest of protecting the jobs of bank executives, and protecting bank bondholders from perhaps a few hundred billion dollars in losses (depositors were never at risk, which should be immediately obvious from studying any bank balance sheet), the Fed created yet another yield-seeking bubble that has encouraged vastly expanded indebtedness in every sector of the economy, and has set U.S. equity market investors up for a likely loss in excess of $20 trillion in market capitalization in the coming years.
A $20 trillion market loss? Preposterous. The audacity – nay – the temerity, as Gary Gulman would say. Unfortunately, that’s how valuations work over the complete cycle. That’s how it was possible to correctly project an -83% loss in tech stocks in March 2000, and a loss in the S&P 500 of about -50% at the 2007 peak. When you’re pushing $40 trillion in U.S. equity market capitalization, the highest multiple of U.S. GDP in history, a loss of half of that capitalization over the completion of the cycle is a conservative estimate. It’s certainly not a worst-case scenario. Also, remember from the 2000-2002 and 2007-2009 collapses that Fed easing does nothing to provoke speculation in periods where investors are risk-averse, because in a risk-averse environment, safe liquidity is a desirable asset rather than an inferior one.
Frankly, wiping out half of U.S. equity market capitalization would not even bring the most reliable measures of market valuation to their historical norms, so that outcome is somewhat less likely than wiping out
two-thirds of market capitalization over the completion of this episode..
What if the bull market continues?Despite our emphatic concerns here, we have no attachment to a hard-negative market outlook or investment stance. If our measures of market internals were to improve, indicating that investors had again taken the speculative bit in their teeth, even our own investment outlook would immediately shift neutral or constructive (though with a safety net given current valuations). That’s the central adaptation that was required of our discipline in this cycle: if market internals are favorable, it’s necessary to adopt a neutral or constructive outlook; even in the face of breathtakingly overextended conditions; even in the face of most extreme valuations in U.S. history, on the measures we find best correlated with actual subsequent market returns.
Though my sense is that the market is currently registering a major bull market peak, suppose that the market is actually poised to double from its current level without any material weakness at all. Frankly, that would be fine, because it’s very unlikely for the market to experience a sustained advance without also recruiting favorable market internals, which would encourage us to shift our stance to a much more constructive outlook (though undoubtedly with a safety net given current valuation extremes). It was our pre-emptive bearish response to “overvalued, overbought, overbullish” features of market action – without deterioration in market internals – that created difficulty for us in recent years.
Regardless of whether the market is destined to advance or collapse, it’s enough to respond to observable market conditions as they change. No opinions or forecasts are actually required. My main reason for discussing a likely market peak here is that the initial decline of a bear market tends to be rather violent. Once prices have dropped sharply, it becomes extremely difficult for investors to reduce their exposure to risk, even when the prospect of additional severe losses remains very high. Instead, they often ride out the entire bear market collapse and eventually abandon stocks in a final panic. If investors don’t get out at the highs, they end up getting out at the lows.
..
One of the best examples of this was July 2000, when the Wall Street Journal ran an article titled (in the print version) “What were we THINKING?” The article reflected on the “arrogance, greed, and optimism” that had already been followed by the collapse of dot-com stocks. My favorite line: “Now we know better. Why didn’t they see it coming?” Unfortunately, that article was published at a point where the Nasdaq still had an 80% loss (not a typo) ahead of it.
Again, the only way to produce bubbles like 1929, 2000 and today is for speculation to continue despite lesser extremes. That doesn’t mean that valuations have failed. It means that speculation has persisted for longer than usual, and that the devastating consequences of hypervaluation are still ahead. Someone has to remain willing to say that out loud. The financial markets are in a bubble. It will end badly.
Given current valuations, even a return to average run-of-the-mill historical norms would result in a loss of about two-thirds of U.S. stock market capitalization. Meanwhile, any significant recession will likely be accompanied by a wave of corporate bankruptcies in a system where corporate debt is easily at the highest percentage of corporate gross value-added in history, and the median corporate credit rating is already just one notch above junk.
..
That’s the problem we have with the ridiculous chorus of milquetoast lip-service from Wall Street about the “possibility of a recession in late-2020,” as if even breathing the R-word is a dire, edgy forecast. Somehow, investors and even Wall Street professionals have come to imagine that a quarterly growth rate of 4% (annualized) somehow takes the possibility of a recession off the table for years. When the next recession arrives, they’re not going to know what hit them.
..
While we presently don’t observe the signs of an oncoming recession, we’re often asked how the market could possibly lose two-thirds of its value without one. The answer is that a recession warning will likely come after market losses are already underway, not before.
..
..For now, and until market conditions shift, there’s an open trap door under the equity market, and it’s a very long way down.
- John P. Hussman, Ph.D.,
The Music Fades Out, October 2, 2018
Context'A global crisis in the current backdrop would make 2008 seem like a walk in the park.'(Banking Reform - English/Dutch) '..a truly stable financial and monetary system for the twenty-first century..'