Hussman - Estimating the Risk of a Market Crash

Excerpted from:  Estimating the Risk of a Market Crash
John P. Hussman, Ph.D.
December 30, 2013


“We thought it was the eighth inning, and it was the ninth. I did not think it would go down 33 percent in 15 days.”
- Stanley Druckenmiller

In April 2000, Stanley Druckenmiller, who managed the phenomenally successful Quantum fund for George Soros, called it quits – saying “I overplayed my hand” in technology stocks. The Nasdaq composite had suffered the first blow of what was to become a much deeper loss, with the index losing an additional 70% by 2002 low. Still, getting out was a good idea in hindsight.

With one of the best records in the industry, Druckenmiller has expressed increasing concerns recently that “all the lobsters are in the pot.” A few weeks ago, he said of equities that he holds “the smallest positions I’ve had,” and warned “a necessary condition for a financial crisis, in my opinion, is too loose monetary policy that encourages people to take undue risk.”

Floyd Norris of the New York Times reported in 2000 that Druckenmiller was actually the second high-profile hedge manager to call it quits in that cycle. The first was Tiger Fund’s Julian Robertson, who had lagged the advance because he (correctly, in hindsight) viewed technology stocks as vastly overvalued. The article quoted an analyst saying “The moral of the story is that irrational markets can kill you. Julian said ‘This is irrational and I won’t play,’ and they carried him out feet first. Druckenmiller said ‘This is irrational and I will play,’ and they carried him out feet first.”

Estimating the Risk of a Market Crash

In effect, if the market is adhering to a “bubble” trajectory, we should not be surprised by a phase of persistent advances toward the end, followed ultimately by a sharp decline that erases a significant amount of prior gains in one fell swoop. This is what I’ve often described as “unpleasant skewness,” and is unpleasant precisely because it has historically emerged in conditions that we identify as “overvalued, overbought, and overbullish.” These conditions are often – at least temporarily – associated with persistent further advances to successive marginal new highs, followed by a steep loss.

With regard to present market conditions, the increasingly severe overvalued, overbought, overbullish features of the market here are coupled with soaring margin debt as speculators accumulate stock with borrowed money; record issuance of low-grade “covenant lite” debt; heavy issuance of new stocks – particularly characterized by speculative narratives; and a price trajectory that is eerily well-described by the mathematics of a “log-periodic bubble” that economist Didier Sornette described a decade ago, and has regularly been observed in financial bubbles across asset classes and countries across history.

Interestingly, the no-arbitrage condition also gives us the mathematical tool to estimate the “hazard rate” or crash probability over any finite horizon. Our estimate is that this probability is soaring here.

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As I noted again approaching the 2007 market peak, the need to wait for some observable “catalyst” to justify a defensive stance is reminiscent of other awful consequences of overvalued, overbought, overbullish, rising-yield syndromes, including the 1987 crash: “Investors could find no news to explain the crash in that instance, except an unusually large trade gap with Germany, so they continued to fear that particular piece of data. But day-to-day news events rarely ‘cause’ large market movements… Once certain extremes are clear in the data, the main cause of a market plunge is usually the inevitability of a market plunge. That's the reason we sometimes have to maintain defensive positions in the face of seemingly good short-term market behavior.”

Sornette described this same regularity a decade ago: “The underlying cause of the crash will be found in the preceding months and years, in the progressively increasing build-up of market cooperativity, or effective interactions between investors, often translated into accelerating ascent of the market price. According to this “critical” point of view, the specific manner by which prices collapsed is not the most important problem: a crash occurs because the market has entered an unstable phase and any small disturbance or process may have triggered the instability. The collapse is fundamentally due to the unstable position; the instantaneous cause of the collapse is secondary. Essentially, anything would work once the system is ripe… a crash has fundamentally endogenous, or internal origin.”

My opinion is that present circumstances will not end well, and that a very finite number of speculators will be able to exit with their paper gains successfully...My guess is that the present speculative advance may have a few percent to run – I’ll be particularly concerned if the market does so in a rapid, uncorrected manner in the next couple of weeks, which could suggest crash probabilities approaching 100% based on the sort of analysis above.