Hussman - Rock-a-Bye-Baby

These are exceptional times; tail-risk option pricing is reflecting extreme complacency as market participants are put to sleep by the Bernanke Put.  Hussman once again provides timely insights and continues with our series of posts into hidden extreme tail risk currently embedded in financial markets.

-----

July 15, 2013
Rock-A-Bye Baby
John P. Hussman, Ph.D.

Rock-a-bye baby
On the treetop
When the wind blows
The cradle will rock

When the bough breaks
The cradle will fall
And down will come baby
Cradle and all

I’ve always thought that singing “Rock-a-bye baby” offers a bizarre lesson to our young, encouraging them to be lulled gently to sleep by describing a scene that should have them wide-eyed with terror. Let’s get this straight. You’ve got this baby, in a cradle, teetering on some fractured bough, at the top of a tree, complacently rocking with each breeze, with baby, cradle, and all facing an inevitable disaster that’s inherent in the situation itself. And everyone is OK with this.

You can see why I chose this song for this week’s market comment.

It’s important to start this discussion by emphasizing that we align our outlook with the prevailing evidence at each point in time. So for example, if a meaningful retreat in valuations was followed by a firming in our broad measures of market internals, our views would become at least moderately constructive even if stocks were still overvalued from a cyclical or secular standpoint. We remain flexible to new evidence.

Given the present evidence, however, my real concern is that much like the rolling tops of 2000 and 2007, each pleasant breeze here lulls investors into complacency – but in the face of overvalued, overbought, overbullish conditions that, from a cyclical and secular standpoint, should probably have them wide-eyed with terror (see Closing Arguments for a broad review of our concerns here). We can’t rule out that the bough will sway for a while longer despite the weight, but we won’t embrace the situation by putting our own baby on the twigs. It’s quite crowded up there already.

To continue reading, click here.