Markets don’t follow math, but are rather more influenced by belief. That, in essence, is why bubbles develop and why trying to call a top is futile.
But, argues portfolio manager John Hussman in his current shareholder letter, the math eventually adds up over complete market cycles — even if market history appears to be “defied over portions of those cycles.”
The Hussman Funds principal describes the psychology of the current market as faith in quantitative easing — a view that QE makes stocks go up even though there is no “mechanistic relationship to stock prices except to make low-risk assets psychologically uncomfortable to hold,” Hussman writes.
Neither theory nor evidence establishes such a relationship, and he cites aggressive Fed easing during the 2000-2002 and 2007-2009 market declines as counterexamples.
“Like the nearly religious belief in the technology bubble, the dot-com boom, the housing bubble, and countless other bubbles across history, people are going to believe what they believe here until reality catches up in the most unpleasant way,” Hussman writes.
But while market psychology supports a rising market, market history has been suggesting a severe correction for two years straight, meaning the ultimate crash should be harsh.
Hussman goes over some familiar ground (to those who have followed his previous warnings) in asserting this case, but also adds a novel mathematical approach as well.
The portfolio manager, who formerly taught economics and international finance at the University of Michigan, calls today’s market “the most hostile, overvalued, overbought, overbullish” he can identify, finding just six comparable points in market history, all of which ended badly.
One of those comparisons is August 1929, whose halcyon market was followed by the 85% decline of the Great Depression. Three other comparable periods were followed by corrections exceeding 50% (November 1972, March 2000 and May 2007); one was followed by a 30% drop (August 1987); and one (January 2011) by a decline of just under 20% but he attributes the limited response to central bank intervention.
The factors our present period shares with these historical reference points include an overvalued market, as seen by a Shiller P/E greater than 18 (the current multiple is 25 — a level seen last in the late 1990s bubble and the three weeks prior to the 1929 peak); an overbought market, as seen by stock prices more than 50% above their 4-year lows; an overbullish market as seen by an index of advisory sentiment that is more than 52% bullish and less than 28% bearish; and rising yields, with 10-year Treasuries yielding higher than six months earlier.
As a result of this market math, Hussman expects that “normal historical regularities will exert themselves with a vengeance” and warns that at these levels even buy-and-hold strategies are mostly inappropriate.
“At a 2% dividend yield on the S&P 500, equities are effectively instruments with 50-year duration. That means that even stock holdings amounting to 10% of assets exhaust a 5-year duration,” Hussman writes.
The former finance professor adds a novel mathematical argument to his arsenal of warnings, this one based on a log-periodic pattern he calls “almost creepy” in the consistency with which successive market troughs come closer and closer in time to the ultimate blowoffs.
“At this point, the only way to extend the singularity beyond the present date is to envision a nearly vertical pre-crash blowoff,” he writes, adding that an “accelerating volatility at micro-intervals” that he is also currently seeing “is closely related to log-periodicity.”
The stock market’s rising heights are a source of both cheer and angst these days, even the subject of a front-page story in Monday’s Wall Street Journal, which notes that Mom-and-Pop investors have finally joined the rally, after sitting out the early years of the rebound.
While stocks are up 24% this year, following four consecutive years of gain, the arrival of Main Street investors to the rally is seen by many as a sign of a market top.
Even still, market bulls abound. Charles Schwab & Co. chief investment strategist Liz Ann Sonders told a large gathering of investors Sunday evening that “the market is quite cheap.”
Check out Nouriel Roubini Warns of Bubbles in the Economic Broth on ThinkAdvisor.