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Speculative Half-Cycles Tend To Be Completed Badly by John Hussman, (22 February 2016)
Excerpt from the article: „Last week, the Cleveland Fed Financial Stress Index climbed to 1.92 (measured as standard deviations from the mean); a level associated with severe financial distress, and previously observed only during the 2011 market retreat, the 2008-2009 financial crisis, and the Asian crisis of 1998. This spike has been driven by widening credit spreads and other measures of systemic market-perceived risk. In 1998, a similar spike shortly preceded the collapse of Long Term Capital Management. In 2008, the spike shortly preceded the failure of Bear Stearns and Lehman Brothers. In 2011, the spike was followed by the failure and restructuring of Greek government debt… Presently, a further 40-50% collapse in the S&P 500 over the completion of this market cycle would not represent a worst-case scenario, but rather a run-of-the-mill outcome from current valuations. That prospect is coupled with an expectation of a U.S. recession, and the likelihood that Fed easing will be wholly ineffective in preventing either….
Over shorter horizons, the primary driver of market fluctuations is the willingness or aversion of investors to embrace risk. Since investors tend to be indiscriminate when they are in a risk-seeking mode, we find that the most reliable measure of that risk-seeking is the uniformity of market internals across a broad range of individual stocks, industries, sectors, and security types, including debt securities of varying creditworthiness. Give us an improvement in those internals, and despite what we view as extreme valuations where dismal long-term returns are baked in the cake, the immediacy of our downside concerns would be reduced…. Bottom line, I recognize that market crashes are outliers, and I should emphasize that present conditions don’t imply the forecast of a market crash. But based on specific conditions that have historically been permissive of deep market losses, investors should certainly be braced for that possibility. I honestly don’t know how to look at the historical evidence currently in hand and say something different. I’ve certainly made my own mistakes in the half-cycle since 2009, and I’ve articulated the central lesson nearly every week since making what I view as the critical adaptation in mid-2014. Those (fully addressed) challenges aside, the conditions and concerns we presently observe are identical to what I expressed at the 2000 and 2007 peaks… Understand that I have no argument with investors who have both the investment horizon and the risk-tolerance to maintain a passive investment strategy. While my impression is that the completion of this cycle may be quite similar to what passive investors had to accept during the 2000-2002 and 2007-2009 market declines, disciplined passive investors recognize the potential depth of those cyclical risks. But they also recognize the potential imperfections of any attempt to actively manage those risks, and decide to follow the passive route. For my part, I prefer following a value-conscious, historically-informed, risk-managed approach, and likewise, I have to accept the periodic risks of that approach (which in the recent half-cycle was mainly that - so long as market internals had not explicitly deteriorated - deranged monetary policy weakened the reliable historical tendency for extreme “overvalued, overbought, overbullish” syndromes to produce abrupt losses)… I’d like to end with some personal thoughts. If you’re an advocate of a passive buy-and-hold strategy, you’re not my enemy, and neither should I be yours. We simply see the world differently. It’s strange to me how much intolerance has infected every aspect of our culture. As meanness and incivility become increasingly acceptable, I think it’s best to push the other way. Incivility is like a broken window - when it becomes acceptable, you get more broken windows, and everything deteriorates. I’ve laid out our concerns and our evidence, and we’re going to do what we’re going to do. To my critics - disagree as you like, but be kind, lest you invite ridicule when the tables turn. Speculative half-cycles, after all, tend to be completed badly.”
Over shorter horizons, the primary driver of market fluctuations is the willingness or aversion of investors to embrace risk. Since investors tend to be indiscriminate when they are in a risk-seeking mode, we find that the most reliable measure of that risk-seeking is the uniformity of market internals across a broad range of individual stocks, industries, sectors, and security types, including debt securities of varying creditworthiness. Give us an improvement in those internals, and despite what we view as extreme valuations where dismal long-term returns are baked in the cake, the immediacy of our downside concerns would be reduced…. Bottom line, I recognize that market crashes are outliers, and I should emphasize that present conditions don’t imply the forecast of a market crash. But based on specific conditions that have historically been permissive of deep market losses, investors should certainly be braced for that possibility. I honestly don’t know how to look at the historical evidence currently in hand and say something different. I’ve certainly made my own mistakes in the half-cycle since 2009, and I’ve articulated the central lesson nearly every week since making what I view as the critical adaptation in mid-2014. Those (fully addressed) challenges aside, the conditions and concerns we presently observe are identical to what I expressed at the 2000 and 2007 peaks… Understand that I have no argument with investors who have both the investment horizon and the risk-tolerance to maintain a passive investment strategy. While my impression is that the completion of this cycle may be quite similar to what passive investors had to accept during the 2000-2002 and 2007-2009 market declines, disciplined passive investors recognize the potential depth of those cyclical risks. But they also recognize the potential imperfections of any attempt to actively manage those risks, and decide to follow the passive route. For my part, I prefer following a value-conscious, historically-informed, risk-managed approach, and likewise, I have to accept the periodic risks of that approach (which in the recent half-cycle was mainly that - so long as market internals had not explicitly deteriorated - deranged monetary policy weakened the reliable historical tendency for extreme “overvalued, overbought, overbullish” syndromes to produce abrupt losses)… I’d like to end with some personal thoughts. If you’re an advocate of a passive buy-and-hold strategy, you’re not my enemy, and neither should I be yours. We simply see the world differently. It’s strange to me how much intolerance has infected every aspect of our culture. As meanness and incivility become increasingly acceptable, I think it’s best to push the other way. Incivility is like a broken window - when it becomes acceptable, you get more broken windows, and everything deteriorates. I’ve laid out our concerns and our evidence, and we’re going to do what we’re going to do. To my critics - disagree as you like, but be kind, lest you invite ridicule when the tables turn. Speculative half-cycles, after all, tend to be completed badly.”
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