Hussman - Excerpts from Weekly Commentary: Baked in the Cake

We tend to feature John Hussman in these pages because his empirically-derived and rigorous analysis augmented by insights developed from extensive experience in managing money (in contrast to talking-heads with "no skin in the game", to quote Taleb) necessitate serious consideration.  Tail-hedging is not a perma-bear strategy, nor is it effective only in doomsday scenarios; on the contrary, it is a hedging strategy that combines a bullish emphasis (by maximising positive outcomes through the elimination of extreme negative ones) with robust risk management (not reliant on theories or models).  In this context, we do not quote Hussman because he is a perma-bear (he is not), but because his insights are instructive in maximising the potential to earn returns over a full market cycle.  It just so happens that in the current market, not only are his indicators flashing red-alert but his instincts derived from extensive experience scream "hedge!" (Hussman employs a protective put option strategy in his funds).  And with good reason, as he explains in his recent weekly commentary.

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July 29, 2013
Baked In The Cake (click to access full report)
John P. Hussman, Ph.D.

Excerpts:
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“The U.S. equity market is now in the third, mature, late-stage, overvalued, overbought, overbullish, Fed-enabled equity bubble in just over a decade. Like the 2000-2002 plunge of 50%, and the 2007-2009 plunge of 55%, the current episode is likely to end tragically. This expectation is not a statement about whether the market will or will not register a marginal new high over the next few weeks or months. It is not predicated on the question of whether or when the Fed will or will not taper its program of quantitative easing. It is predicated instead on the fact that the deepest market losses in history have always emerged from an identical set of conditions (also evident at the pre-crash peaks of 1929, 1972, and 1987) – namely, an extreme syndrome of overvalued, overbought, overbullish conditions, generally in the context of rising long-term interest rates.”
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“Despite individual features that convinced investors in each instance that “this time is different”, the corresponding handful of truly breathtaking market losses in history have a single source: the willingness of investors to forego the need for a risk premium on securities that have always required one over time. Once the risk premium is beaten out of stocks, there is no way out, and nothing that can be done about it. Poor subsequent returns, market losses, and the associated destruction of financial security (at least for the bag-holders) are already baked in the cake. This should have been the lesson gleaned from the period since 2000, but because it remains unlearned, it will also become the lesson of the coming decade. “
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“With respect to the present, mature, overvalued, speculative half-cycle, I don't expect this cycle to be completed with a 20% loss, or a 25% loss, but instead a loss in the 40-55% range. Again - this isn't even a dire forecast. A 40% market loss is the central expectation.”
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“The Shiller P/E is now 24.4, about the same level as August 1929, higher than December 1972, higher than August 1987, but less extreme than the level of 43 that was reached in March 2000 (a level that has been followed by more than 13 years of market returns within a fraction of a percent of the return on Treasury bills – and even then only by revisiting significantly overvalued levels today). The Shiller P/E is presently moderately below the level of 27 at the October 2007 market peak.”
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“In short, we have one of the most overvalued, overbought, overbullish equity markets in history, but one where investors are under the illusion that stocks are appropriately priced, because they are being sold a valuation benchmark (forward operating earnings) that reflects profit margins 70% above historical norms – a direct result of unsustainably large deficits in combined government and household savings.”
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“Let’s be clear about something. Since 2000, the S&P 500 has achieved an average annual total return barely higher than 2% annually, and even then only by re-establishing overvalued levels at present. If there was any period since the Depression to be concerned about valuations and market risk, this has been the time – and it continues.”
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“Frankly, I still view QE as a confidence game that has no financial mechanism except to make investors uncomfortable holding Treasury bills, and no theoretically valid or empirically supported transmission mechanism to the real economy at all. I’m both surprised and a little bit disappointed that investors have again placed their confidence and financial security on what is the economic equivalent of a cheap parlor trick.”
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“For those who trust my judgment, I can tell you not only that we are far, far more inclined to encourage constructive and aggressive investment exposures over the course of the complete market cycle than casual observers may recognize – but I will also tell you that the stock market – here and now – is at a far, far more dangerous point in that cycle than investors can imagine.”
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“A final note – be aware that overvalued, overbought, overbullish periods often feature what I’ve called “unpleasant skew.” As I noted before significant corrections in 2010 and 2011: “If you look at overvalued, overbought, overbullish, hostile yield conditions of the past, you'll find that the most likely market outcome, in terms of raw probability, is a continued tendency for the market to achieve successive but slight marginal new highs. While this movement tends to be fairly muted in terms of overall progress, it can be somewhat excruciating for investors in a defensive position, because the market tends to pull back by a only a few percent, followed by bursts that recover that lost ground and achieve minor but widely celebrated new highs. That is the ‘unpleasant’ part. The ‘skew’ part is that although the raw probability tends to favor slight successive new highs, the remaining probability tends to feature nearly vertical drops, typically well over 10% over a period of weeks.””