Hussman - All of the Above

Continuing with commentary on the current high level of tail-risk in financial markets, John Hussman provides a compelling insight: "Market crashes are always driven by a spike in risk premiums from previously inadequate levels".

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Weekly Market Comment
All of the Above
By John P. Hussman, Ph.D.
July 1, 2013

Excerpt:

One of the results of writing on a wide range of economic and financial topics is that investors sometimes assume that my market views are dependent on some particular data point or Fed decision. Current events are interesting in the sense that they can affect the various measures that we use to classify market conditions, but those measures are actually what matter most because they can be tested and validated across history. In a nutshell, here are some of the basic conditions that I believe are relevant for risk-taking in stocks, and the order in which I tend to consider them:

First, an overvalued, overbought, overbullish syndrome of conditions has historically trumped all other considerations – on average – particularly when yields are rising and price momentum has flattened. Market crashes are always driven by a spike in risk premiums from previously inadequate levels. Never forget that. When risk premiums are squeezed to deeply depressed levels (as QE has done) and upward pressures on those risk premiums then emerge, markets collapse.

Absent that syndrome, favorable market internals and trend-following conditions generally dominate other considerations. Valuations are the primary determinant of long-term returns, but over shorter horizons, valuations are essentially a “modifier” – meaning that the stocks typically enjoy the strongest gains of the market cycle when broad market action is positive and favorable valuations provide a tailwind.

The lesson from Depression-era data isn’t different in this regard. Rather, Depression-era data teaches that neither favorable trend-following measures (which were heavily whipsawed) nor favorable valuations were enough to avoid deep losses until they were confirmed by positive divergences in market internals and other measures. I think that’s probably what Jesse Livermore had in mind when he wrote “It isn’t as important to buy as cheap as possible as it is to buy at the right time.” Livermore also observed that his worst losses were the result of lapses in the discipline of investing “only when I was satisfied that precedents favoured my play.” Few things in finance are truly unprecedented – including the Depression and QE – once you quantify how they exert their influence on the variables that determine prices (cash flows, growth rates, risk-free discount rates and risk premiums).

In the absence of favorable market internals, easy monetary policy is far less helpful than investors believe. From an asset allocation perspective, even simple trend-following methods have performed far better than following monetary policy. QE has undoubtedly complicated the period since 2010, but a good part of that difficulty was actually during periods when market internals were favorable while an overvalued, overbought, overbullish syndrome was absent. Most of the remaining difficulty has been over the past year, as stocks have advanced despite a persistent overvalued, overbought, overbullish syndrome – contrary to average historical outcomes. Then again, I suspect that it will be striking how quickly those gains are surrendered if market internals remain broken.

What’s disturbing, if you actually examine the historical evidence, is that while favorable market action tends to be favorable regardless of the monetary policy stance, unfavorable market action coupled with easy money is actually more hostile than unfavorable market action coupled with tight money. As I noted in Following the Fed to 50% Flops, “Strikingly, the maximum drawdown of the S&P 500, confined to periods of favorable monetary conditions since 1940, would have been a 55% loss. This compares with a 33% loss during unfavorable monetary conditions. This is worth repeating – favorable monetary conditions were associated with far deeper drawdowns.”

I’ll end by repeating what I view as the most important risk at present. Hands-down, the worst-case scenario for investors is a market that comes off of a syndrome of overvalued, overbought, overbullish conditions and then breaks trend-support in the context of an economic downturn. Market crashes are always driven by a spike in risk premiums from previously inadequate levels, and that sequence of events would be the perfect storm.

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