Hussman - Topping Patterns and the Proper Cause for Optimism

Weekly Market Comment
by John Hussman
17 February 2014

Excerpts:

Following a moderate decline from its recent highs, the market experienced a “reflex” advance last week. As I noted in the February 3 comment, “Even the shallow 3% retreat from the market’s all-time highs may be enough to prompt a reflexive ‘buy-the-dip’ response in the context of extreme bullish sentiment here, as the S&P 500 bounced off of a widely monitored and steeply ascending trendline last week that connects several short-term market lows over the past year. Regardless, the potential for short-term gains is overwhelmed by the risk of deep cyclical and secular losses.”

Needless to say, our concerns are little changed by the last week’s advance, and with this low-volume reflex rally in place, we may observe a much deeper and uncorrected loss if the prior resolutions of severely overvalued, overbought, overbullish, rising-yield conditions are an indication.

We would dismiss historical analogs like this if the recent market peak did not feature the “full catastrophe” of textbook speculative features – particularly the same syndrome of extreme overvalued, overbought, overbullish, rising-yield conditions observed (prior to the past year) only at major market peaks in 2007, 2000, 1987, 1972, and 1929. The main temptation to ignore this concern is that similarly extreme conditions emerged in both February and May 2013 without consequence. Less extreme variants of this syndrome have also emerged periodically in the past few years (these variants also capture 1937 and a few other bull market peaks, as well as the April 2011 peak after which the market briefly retreated by nearly 20%). Overall, my view continues to be that the consequences of the more recent instances have not been avoided, but merely deferred – and those consequences will be worse for it."

Regardless of the patterns that have emerged in recent months, it’s important to recognize that the implications of extremely overvalued, overbought, overbullish conditions are not necessarily immediate. In 2000, the March high was followed by a series of retreats and recoveries, with a marginal new high in total-return terms as late as September 2000 before the market lost half of its value. In 2007, the August high was followed by an initial retreat and recovery into a very marginal final peak in October 2007 before the market lost half of its value. In 1972-73, an initial decline of nearly 20% from the market peak was followed by an advance in October 1973 that brought the S&P 500 and Dow Industrials within 7% of their highs before completing a near-50% market loss. In contrast, the reflex advances from the 1987 and 1929 peaks were rather short-lived, and were followed by steep losses within a span of weeks. Market cycles often display regularities, but investors should never conclude that they follow precise rules.