Hussman Weekly Market Comment: Dancing at the Edge of a Cliff

Present market risks involve a confluence of factors. First, valuations remain unusually rich. Though prospective returns are better than at the 2000 and 2007 peaks, valuations remain more elevated than at any point prior to the late-1990's bubble, save for the period before the 1929 plunge. Notably, valuations only seem "reasonable" on the basis of "forward operating earnings" if one ignores the fact that profit margins are 50-70% above historical norms, and are dependent on unsustainably large fiscal deficits and depressed household saving in order for that to continue (see Too Little to Lock In).

Second, market internals have deteriorated, with an uncomfortably familiar "two-tier" profile developing between a handful of speculative momentum stocks and the broader market. Coupled with an active new issues calendar, near-panic levels of selling by corporate insiders, heavy beta exposure among mutual funds and institutional managers, record-low mutual fund cash levels, and advisory bearishness at just 20.5% (a level last seen before the steep 2011 decline), there appears to be a lopsided exposure to risk among speculators, and a divestment among issuers.

Third, as I've frequently noted, the best way to extract meaningful signals and reduce noise in volatile data is to draw those signals from the joint behavior of several indicators. While these methods range from the simple to the complex, we've frequently presented variously defined sets of indicators (see An Angry Army of Aunt Minnies) that capture some particular investment environment (such as an overvalued, overbought, overbullish market where favorable drivers have begun to drop away). In recent weeks, we've seen several of these hostile syndromes emerge, as I've detailed in prior weekly comments.

Finally, though our overall assessment of market return/risk prospects is largely independent of our macroeconomic concerns, the joint deterioration in the growth of real personal income, real personal consumption, real final sales, and employment, coupled with our inference of leading economic pressures from "unobserved components" methods, creates not only the concern but the expectation that the U.S. economy is entering a recession - not a quarter or two from today, but most likely at present. Indeed, Europe already appears to be in a broadening recession, which the U.K. has now joined, and the confluence of economic weakness and already strained government debt conditions in Europe is likely to produce disruptive outcomes in the coming quarters.