Hussman - The Line Between Rational Speculation and Market Collapse

To look at the past 14 years and draw the lesson that rich valuations can be ignored (even when market internals and credit spreads are deteriorating), that hedging is a fool’s game, and that Fed easing can be relied on to drive stock prices higher, is to forget the principal lessons from the most severe market losses that the equity market has endured throughout history. What repeatedly distinguishes bubbles from the crashes is the pairing of severely overvalued, overbought, overbullish conditions with a subtle but measurable deterioration in market internals or credit spreads that conveys a shift from risk-seeking to risk-aversion.

As for monetary policy, remember that the Fed did not tighten in 1929, but instead began cutting interest rates on February 11, 1930 – nearly two and a half years before the market bottomed. The Fed cut rates on January 3, 2001 just as a two-year bear market collapse was starting, and kept cutting all the way down. The Fed cut the federal funds rate on September 18, 2007 – several weeks before the top of the market, and kept cutting all the way down.  Many of the distinctions that investors believe are important are actually useless  in avoiding steep market losses, and many of the distinctions that investors are ignoring at present are absolutely critical.

So for those who value and rely on our work, know that I do see the challenging transition of recent years as fully addressed, as the adaptations we’ve made are robust to data from every market cycle we’ve observed across a century of history. We’ve got much to show for our efforts in recent years. I expect that it will be great fun, once again, to demonstrate it all in practice, as we did in the years prior to 2009 (and with any luck, even more clearly).

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“I cannot imagine any condition which would cause a ship to founder. I cannot conceive of any vital disaster happening to this vessel. Modern shipbuilding has gone beyond that.”
- Edward Smith, Captain, RMS Titanic

“One reason that risk premiums may be low is precisely because the environment is less risky… The Fed has long focused on ensuring that banks hold adequate capital and that they carefully monitor and manage risks. As a consequence, banks are well-positioned to weather the financial turmoil.”
- Janet Yellen, July-September 2007