'Still, because we don’t rely on that sort of permanently high plateau, it’s critical to understand just how extreme valuations have become..''Among the most persistent questions I hear is why we don’t just adapt to the reality that the Federal Reserve will never again “allow” the market to experience a serious decline. The problem with this view is that it rests on the premise that Federal Reserve policy supports the market in a clear-cut and
mechanical way, when its effectiveness actually relies on the
speculative psychology of investors.
..
It’s terribly dangerous to assume that the prevailing extreme of speculative psychology is permanent. In our work, the most reliable gauge of whether investors lean toward speculation or risk aversion is the
uniformity of market internals across thousands of stocks, industries, sectors, and security types, including debt securities of varying creditworthiness. When investors are inclined to speculate, they tend to be indiscriminate about it. Across a century of market cycles, including the peak-to-peak market cycle from 2007 to the recent market highs, the entire gain of the S&P 500 in excess of Treasury bills has occurred in periods when our primary gauge of market internals has been favorable, while the deepest market losses, including those in the recent market cycle, have occurred when they were not.
Amid the most extreme valuations in history, we’ve observed gradual deterioration in our measures of internals in recent months, with breakdowns among individual stocks in the broad market accelerating in recent weeks. For that reason, our present investment outlook can be classified as clearly defensive. Yet that outlook will also ease immediately if our measures of market internals were to improve. We would expect to adopt at least a moderately constructive outlook if the improvement in market internals follows a material retreat in valuations – even one that takes valuations nowhere near historical norms.
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The main adaptation that deranged Federal Reserve policy required of our own discipline in this cycle was to abandon our pre-emptive bearish response to historically-reliable “limits” to speculation, and to instead prioritize the condition of market internals (which have been part of our discipline since 1988). Essentially, we became content to gauge the
presence or absence of speculation or risk-aversion, without assuming that there remains any well-defined
limit to either.
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Still, our research efforts in recent years have focused on adaptations that can allow us to better tolerate and even thrive in a world where valuations might never again retreat to their historical norms. We don’t actually expect that sort of world, but have allowed for it. These adaptations basically amount to criteria for accepting moderate amounts of market exposure – coupled with position limits or safety nets that constrain risk – even in conditions where valuations imply poor long-term returns. These criteria fall into what Graham would describe as “intelligent speculation” – kept within minor limits.
We’ve already benefited from some of this research, particularly since early 2020, and I expect the impact will become far more evident over time, especially at points where a material retreat in valuations – though possibly nowhere near historical norms – is joined by certain improvements in our gauges of market action. As usual, we’ll allow the data to determine those shifts.
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In prior market cycles, including the 2000 and 2007 peaks, attending to the combination of valuations and market internals has been the most reliable way we’ve found to navigate both speculative bubbles and risk-averse collapses. In the recent cycle, our main difficulty was to rely on historically-reliable “limits” to speculation. Our main adaptation was simply to become content with attending to the combination of valuations and market internals – just without assuming that speculative or risk-averse investor psychology still has limits. I do believe that we can tolerate and even thrive in a world where valuations might never again retreat to their historical norms.
Still, because we don’t rely on that sort of permanently high plateau, it’s critical to understand just how extreme valuations have become..
..
Having devoted much of period since early-2020 to pandemic-related research and policy efforts as part of the work of the Hussman Foundation, many of these market comments have included a public health note. As I detail in the one at the end of this comment, I believe we’ve reached the peak of the Delta wave, which has remained the most infectious SARS-CoV-2 variant of concern. Caution will still be important for several more weeks, but I expect a clear retreat in the pandemic trajectory here, and this would be remarkably good news.
The not-so-good news is that from an economic standpoint, investors seem to have little appreciation of the extent to which trillions of dollars in Federal pandemic relief funds have supported the economy, and the contribution that these deficits have made to household savings, corporate profits, and the financing of record trade deficits in recent quarters. Even the deficit contemplated in existing budget legislation comes nowhere near replacing this impact. So a recovery in the private economy will have to pick up the slack just to hold steady. On that point, U.S. nonfarm employment is still 5 million jobs short of what it was before the pandemic, and both extended unemployment benefits and eviction protections have just come off.
..
In short,
private economic activity should improve markedly as this pandemic subsides, but that activity will
replace, not
augment, the impact of trillions in deficit spending that is going away. It’s not at all clear that gross economic activity will increase. As the size of the Federal deficit declines from its extraordinarily high level, we may see much greater pressure on household savings and corporate profits than Wall Street seems to assume.
..
As usual, no forecasts are actually necessary here. We’ll respond to shifts in valuations, market internals, and other measures as they emerge. Still, it’s useful to consider the possibility that even enormously good news for public health may not translate into particularly favorable outcomes for the overall economy.
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Much of the world remains unvaccinated, which is where our attention should turn. The easiest way to induce mutations in a virus is to serially passage it from host to host. There are certainly mutations to various parts of the virus (binding domain, replication machinery, cleavage site, neutralization epitopes) that one wouldn’t want to see together in a single variant, so we’re not entirely out of the woods. Certain variants of interest like Lambda have undesirable features, but they don’t appear sufficient to dominate Delta. We can’t rule out a future betacoronavirus pandemic, just as we can’t rule out a future influenza pandemic. It would be nice, before the next one, for the public to learn their math and science from somewhere other than social media.
In any event, based on the present set of conditions in the U.S., my expectation is that the SARS-CoV-2 pandemic will rapidly subside in the weeks ahead.'
- John P. Hussman, Ph.D.,
Maladaptive Beliefs, September 12, 2021
Context'Throwing Credit at such an acutely imbalanced economic structure at a cycle inflection point is fraught with risk.'Valuations and Coming One-, Three-, Five-, Seven-, Nine-, and 11-Year Returns, September 3, 2021
Workers Only Make 8 Cents More Per Hour, Inflation-Adjusted, Than January 1973, September 15, 2021
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