Monday, March 8, 2010

Hussman Weekly Market Comment: The Rubber Hits the Road

A deleveraging cycle is much like a secular bear market in that the market experiences a great deal of volatility, but tends to establish a sequence of troughs, each at lower levels of valuation (even if not at lower absolute prices). In that environment, there is significant risk of abrupt spikes in risk aversion (which implies abrupt price spikes to the downside), so you can't trade with "hot" valuation or market action criteria. It should be no surprise that Graham and Dodd wrote Security Analysis following the post-credit crisis period of the 1920's and 1930's. If there's one lesson from those environments, it is that valuations and the idea of a "margin of safety" takes precedence over all other considerations.

In post-war data where investors have not been concerned about credit and banking crises (and especially since the mid-1990's), valuations have been a less reliable investment guide except over the complete bull-bear cycle. Even in the face of valuation bubbles and pertinent risks that have predictably harmed investors over the longer term, investors have demonstrated themselves to be quite willing to ignore those risks and speculate. While there has always been this element in post-war data, it has become very exaggerated in the past 15 years. An important feature of post-war cycles is that when credit crisis is not a concern, you've generally been able to cut losses before the real damage is done by paying very strict attention to market internals. Risk aversion doesn't spike as abruptly. In contrast, the losses in a credit crisis can slam investors from left field.

Basically, trends, technicals and market internals have played a larger role in post-war data, and particularly since 1995, allowing the market to periodically tolerate valuations that would have collapsed much sooner in earlier times. Still, valuations have remained important in determining the extent to which market returns are durable. Ultimately, valuations have determined long-term returns regardless of what portion of history you examine. Speculative advances in richly valued markets are invariably surrendered later.

The S&P 500 is still below where it was a decade ago, and even with the benefit of its recent advance, has underperformed Treasury bills for nearly 13 years. The reason is that investors could not have cared less about valuations during the late-1990's, and failed to recognize that they were still inappropriately rich between 2004-2007 (as they are again today). Speculators can get all kinds of enticing advances going over the short-term, but over time (complete market cycles and longer), regardless of whether one looks at post-war data or pre-war data, valuations determine the long-term returns that investors achieve in stocks.


Last week, we observed a subtle shift in yield pressures, which has historically been associated with fairly abrupt "air pockets" in which stocks have typically lost 10% or more within the span of about 6 weeks. As usual, this isn't a forecast, but given that we are already defensive on the basis of broader considerations about overvaluation and the overbought status of the market, the pressures we're seeing on the yield front make our aversion to market risk somewhat more pointed.