Peaking Process
John P. Hussman, Ph.D.
In my view, we are likely witnessing the peak of the third equity valuation bubble in the past 14 years, the first two which saw major indices plunge by at least 50%. It’s important to recognize that market peaks are a process, not an event. Internal deterioration has actually been developing since early July, and became measurable in early August (see A Hint of Advance Warning). This process has been quite like what we observed in 2007, when deterioration became measurable in July of that year (see Market Internals Go Negative). Despite an initial selloff, the major indices recovered to a marginal new high in October 2007 before continuing lower.
As conditions presently stand, the equity market remains vulnerable to the same kind of abrupt air-pocket we observed several weeks ago. We don’t need to make forecasts however – if market internals and credit spreads improve, the immediacy of our concerns will ease considerably. It’s just that we presently observe a combination of evidence that has generally been disastrous over time (see A Most Important Distinction for a chart of the cumulative performance of the S&P 500 under conditions matching what we presently observe).
On the valuation front, based on measures that we find most reliably correlated with actual subsequent market returns (and many widely-quoted measures are not), equities are more overvalued than at any point in history except 2000, at more than double their historical norms, and the best-correlated ones are within 15% of the 2000 peak (seeOckham’s Razor and the Market Cycle to review a variety of these). With market internals still struggling and credit spreads widening, elevated valuations have now been joined by a subtle but measurable shift toward increasing risk aversion. In prior cycles, that shift has typically discriminated between overvalued markets that continued higher from overvalued markets that fell like a stone. Again, if that evidence eases, the immediacy of our concerns will ease as well. That wouldn’t make stocks any less overvalued, so a certain line of defense will be important in any event.
Here and now, the simple fact is that we observe conditions that have historically been associated with very little but air-pockets, free-falls, and crashes. In the past few months, trend-sensitive components of our discipline (involving credit spreads, market internals, and other features of market action that I sometimes describe collectively as “trend uniformity”) have been deteriorating, suggesting a shift toward risk aversion in the face of extreme overvaluation, even as the major indices have been pushing to marginal new highs.
That combination of rich valuations, lopsided bullish sentiment, overbought conditions, and importantly, deteriorating market internals, has been critical in identifying major equity market risk over time. As I noted at the October 2007 peak (see Warning: Examine All Risk Exposures):
“If we partition history into ‘buckets’ according to the Market Climate that was prevailing at the time, and look at how the market performed over say, the next week, month, or quarter we find that every bucket includes periods that were followed by advances, as well as periods that were followed by declines. In other words, we can rarely predict that the market will reliably advance or decline over the next week or month or quarter. What wecan say is that the average return/risk profile varies substantially across buckets. Given observations over at least one complete market cycle, we regularly find that the strongestaverage return/risk profile was associated with periods that one could identify in advanceas having favorable valuation and (already) favorable market action, and that the poorest subsequent return/risk profile was associated with the bucket of periods having unfavorable valuation and unfavorable market action. Over the complete market cycle, this knowledge has generally been enough to achieve strong full-cycle returns with moderate risk.”
The main challenge to a hedged investment approach in recent months has not been a runaway bull market that is violating historical regularities. Rather, the main challenge is the short-term effect of those internal breakdowns, as the more democratic equity indices remain below their July highs (see for example the Russell 2000 and the NYSE Composite), while the mega-cap weighted indices such as the S&P 500 and Nasdaq 100 have advanced about 5% and 10% further, respectively. That sort of “basis widening” is uncomfortable for hedged strategies, but in the context of overvalued market conditions, it also tends to be a precursor to major market losses.
