'For the most part, markets have been mesmerized by a flock of dovish global central bankers – while ignoring gathering storm clouds. Yet Z.1 data are a reminder of how quickly the markets buckled back in the fourth quarter. By now, I’ll assume the vigorous short squeeze and unwind of hedges have pretty much run their course. It has me pondering the next leg down in the unfolding bear market.
At some point, it’s not going to be as easy for central bankers and Beijing to reverse faltering markets. A big surge in Broker/Dealer assets, “repo” and bank lending would prove problematic if, instead of recovering, markets continue sinking into illiquidity. Financial conditions would tighten dramatically. No junk – or investment-grade issuance. Q4 ETF outflows and derivative issues offered a hint of what’s to come. Foreign buyers have been losing interest in U.S. securities. And definitely don’t rule out a quick $10 TN drop in Household Net Worth – and attendant major economic ramifications. Silly me. Annual $2.0 Trillion federal deficits effortlessly monetized by our accommodating central bank will cure all ills – financial, economic, social, geopolitical and otherwise. Global policymakers will regret becoming so adept at stoking speculative excess.'
- Doug Noland,
Q4 2018 Z.1 "Flow of Funds", March 9, 2019
'Look. The next couple of years are likely to include several breathtaking waterfall declines, and several more “fast, furious, prone-to-failure” clearing rallies. Investors who study market history will find the progression familiar. Investors who instead dismiss the fact that extreme valuations have always been followed by collapse to run-of-the-mill valuation norms (which would currently require a roughly -60% loss in the S&P 500) are in for a difficult history lesson.''In 2009, once the S&P 500 had collapsed by over -55% and investors shifted toward a speculative mindset, quantitative easing and zero interest rates became a highly effective tool to encourage speculation. The speculation continued well beyond the point that rich valuations were restored. Given an expanding economy and a sufficiently speculative mindset, extreme syndromes of “overvalued, overbought, overbullish” conditions did nothing to limit continued speculation, as they had in prior cycles across history. By necessity, we had to abandon the belief that reckless speculation had “limits,” and we became content to use market internals to identify the presence or absence of speculative pressures, using valuations to gauge prospects for long-term market returns and full-cycle risks.
Recall, however, that the Fed cut rates aggressively and persistently to no effect throughout the 2000-2002 and 2007-2009 market collapses. When investors are inclined toward risk-aversion, safe liquidity is viewed as a desirable asset, not an inferior one. So creating more of the stuff doesn’t reliably provoke speculation. This is a fact that investors are likely to relearn the hard way during the next financial collapse.
What’s striking about the bounce from December’s lows is how eager Wall Street is to dismiss it in hindsight as “overdone,” “reckless,” and “stupid.” Some blame the decline on nefarious “algorithms,” while others credit the subsequent bounce to some behind-the-scenes “plunge protection team.”
Look. The next couple of years are likely to include several breathtaking waterfall declines, and several more “fast, furious, prone-to-failure” clearing rallies. Investors who study market history will find the progression familiar. Investors who instead dismiss the fact that extreme valuations have always been followed by collapse to run-of-the-mill valuation norms (which would currently require a roughly -60% loss in the S&P 500) are in for a difficult history lesson.
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For now, a fairly neutral short-term outlook adequately balances extremely negative cyclical conditions with shorter-term Fed-focused exuberance. We’ve learned never to fight speculation unless internals are clearly negative. You can wave your arms around about valuations and full-cycle risks, you can point out how and why other bubbles collapsed, you can trot out a century of historical data, but if we’ve learned one thing about Wall Street, it’s that, As Ron White says, “you can’t fix stupid.” You’ll only injure yourself trying.
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I continue to believe that September 20, 2018 marked the most likely peak of the recent bull market, and that the recent advance most likely represents an aging bear market rally, with steep full-cycle market losses being inevitable. It’s also important to observe the similarity of the recent advance to the short-lived clearing rallies of early-2001 and early-2008, both which restored borderline market internals before failing.
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Despite a fairly neutral near-term view, my full-cycle outlook remains very pointed. This is an obscenely overvalued market. Looking over the completion of this market cycle (perhaps 18-30 months), I continue to expect a loss in the S&P 500 approaching roughly -60%, with a negative total return for the S&P 500 over the coming 12-year horizon. It’s exactly because those projections seem preposterous, and exactly because our expectations for similar losses in 2000 and 2007 were reliably correct, that a careful review of market conditions is essential here.
It’s important to understand “what it is normal to hope for.” I remain deeply concerned that investors have come to believe that the link between valuations and subsequent investment returns has been abolished. The problem is that while valuations are extremely informative about long-term market outcomes and full-cycle risks, overvaluation often fails to have any short-term consequence. Indeed, if overvaluation always provoked immediate market losses, it would be impossible for valuations to scale to the heights they reached in 1929, 2000 and today.
To defer the consequences of extreme overvaluation is also to magnify them. That’s the fact that investors repeatedly miss, and the fact that is so destructive over the complete market cycle. The more extreme valuations become, the more systemic the impact of the subsequent collapse.
To quote Howard Marks again, whose investment philosophy is broadly consistent with my own, “Cycles have more potential to wreak havoc the further they progress from that midpoint – i.e., the greater the aberrations or excesses. If the swing toward one extreme goes further, the swing back is likely to be more violent, and the more damage is likely to be done, as actions encouraged by the cycle’s operation at an extreme prove unsuitable for life elsewhere in the cycle.”
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Now, it’s certainly possible to estimate the value of the S&P 500 using lower rates of discount, as long as you accept that the resulting price implies a similarly lower level of expected future returns. The chart below shows the impact of doing so. In my view, passive investors will be rather fortunate if the completion of this cycle draws the S&P 500 only to 1482, which would represent a roughly -50% loss from the September 2018 peak. Though the 2000-2002 decline didn’t bring valuations to the 8% line, those trough valuations were not durable, and the S&P 500 broke even lower during the 2007-2009 collapse.
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In summary, with the total equity market capitalization of U.S. financial and nonfinancial corporations now over $40 trillion, the highest multiple of GDP in history, we expect dismal consequences for the U.S. stock market over the completion of this cycle, and over the coming 10-12 years. Yet the historical reality is that once speculation shifts to risk-aversion, a period of just 18-30 months is typically required for valuations to revert to average or below-average levels, creating fresh opportunity for value-conscious long-term investors.
At present, we’re observing a clear fight between speculation and risk-aversion, with exuberance about the Federal Reserve “caving” back to dovish behavior encouraging investors that they can ignore valuations and even deteriorating economic measures. Despite full-cycle risks, it’s not clear how this fight will be resolved over the near-term. We’ve learned in this cycle that the tenacity of speculators can’t be underestimated, so with market internals at the threshold between speculation and risk-aversion, it’s best not to stand too strongly in either direction.'
- John P Hussman, Ph.D.,
Ground Rules of Existence, March 3, 2019
Context'..inflation cannot be considered as a way of life and that it is imperative to return to sound monetary policies.''..The risk is rising that the U.S. will not only return to zero short rates but, as they have in Japan..''..global Credit Bubbles have become highly synchronized..'