Hussman Funds - Weekly Market Comment: A Textbook Pre-Crash B...

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November 11, 2013

A Textbook Pre-Crash Bubble
Weekly Market Comment Archive Investment Research & Insight Page

John P. Hussman, Ph.D. All rights reserved and actively enforced.

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Investors who believe that history has lessons to teach should take our present concerns with significa but should also recognize that tendencies that repeatedly prove reliable over complete market cycles a sometimes defied over portions of those cycles. Meanwhile, investors who are convinced that this time can ignore what follows. The primary reason not to listen to a word of it is that similar concerns, particu late-2011, have been followed by yet further market gains. If one places full weight on this recent perio weight on history, it follows that stocks can only advance forever.

What seems different this time, enough to revive the conclusion that this time is different, is faith in th Reserves policy of quantitative easing. Though quantitative easing has no mechanistic relationship to prices except to make low-risk assets psychologically uncomfortable to hold, investors place far more c the effectiveness of QE than can be demonstrated by either theory or evidence. The argument essentia reduces to a claim that QE makes stocks go up because it just does. We doubt that the perception th Fed can hold stock prices up will be any more durable in the next couple of years than it was in the 200 decline or the 2007-2009 decline both periods of persistent and aggressive Fed easing. But QE is no like the internet bubble, novelty feeds imagination. Most of what investors believe about QE is imagina

As Ray Dalio of Bridgwater recently observed, The dilemma the Fed faces now is that the tools curren disposal are pretty much used up. We think the question around the effectiveness of QE (and not the ta which gets all the headlines) is the big deal. In other words, were not worried about whether the Fed is hit or release the gas pedal, were worried about whether theres much gas left in the tank and what wi there isnt.

While we can make our case on the basis of fact, theory, data, history, and sometimes just basic arithm we cant do and havent done well is to disabuse perceptions. Beliefs are what they are, and are on malleable as the minds that hold them. Like the nearly religious belief in the technology bubble, the dot boom, the housing bubble, and countless other bubbles across history, people are going to believe wha believe here until reality catches up in the most unpleasant way. The resilience of the market late in a b part of the reason investors keep holding and hoping all the way down. In this market cycle, as in all m cycles, few investors will be able to unload their holdings to the last of the greater fools just after the m peak. Instead, most investors will hold all the way down, because even the initial decline will provoke th question how much lower could it go? It has always been that way.

The problem with bubbles is that they force one to decide whether to look like an idiot before the peak, after the peak. Theres no calling the top, and most of the signals that have been most historically usef purpose have been blaring red since late-2011.

As a result, the Shiller P/E (the S&P 500 divided by the 10-year average of inflation-adjusted earnings) above 25, a level that prior to the late-1990s bubble was seen only in the three weeks prior to the 1929 Meanwhile, the price/revenue ratio of the S&P 500 is now double its pre-bubble norm, as is the ratio of market capitalization to GDP. Indeed, the median price/revenue ratio of the S&P 500 is actually above peak largely because small cap stocks were much more reasonably priced in 2000 than they are tod those better relative valuations prevented wicked losses in small caps during the 2000-2002 decline).

Despite the unusually extended period of speculation as a result of faith in quantitative easing, I continu believe that normal historical regularities will exert themselves with a vengeance over the completion o market cycle. Importantly, the market has now re-established the most hostile overvalued, overbought, overbullish syndrome we identify. Outside of 2013, weve observed this syndrome at only 6 other points August 1929 (followed by the 85% market decline of the Great Depression), November 1972 (followed market plunge in excess of 50%), August 1987 (followed by a market crash in excess of 30%), March 2

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(followed by a market plunge in excess of 50%), May 2007 (followed by a market plunge in excess of 5 January 2011 (followed by a market decline limited to just under 20% as a result of central bank interve

These concerns are easily ignored since we also observed them at lower levels this year, both in Febru Reluctant Bears Guide to the Universe) and in May. Still, the fact is that this syndrome of overvalued, overbo overbullish, rising-yield conditions has emerged near the most significant market peaks and preceded severe market declines in history:

1. S&P 500 Index overvalued, with the Shiller P/E (S&P 500 divided by the 10-year average of inflation earnings) greater than 18. The present multiple is actually 25.

2. S&P 500 Index overbought, with the index more than 7% above its 52-week smoothing, at least 50% 4-year low, and within 3% of its upper Bollinger bands (2 standard deviations above the 20-period mov average) at daily, weekly, and monthly resolutions. Presently, the S&P 500 is either at or slightly throug those bands.

3. Investor sentiment overbullish (Investors Intelligence), with the 2-week average of advisory bulls greate and bearishness below 28%. The most recent weekly figures were 55.2% vs. 15.6%. The sentiment fig use for 1929 are imputed using the extent and volatility of prior market movements, which explains a si amount of variation in investor sentiment over time. 4. Yields rising, with the 10-year Treasury yield higher than 6 months earlier.

The blue bars in the chart below depict the complete set of instances since 1970 when these condition been observed.

Our investment approach remains to align our investment outlook with the prospective market return/ris that we estimate on the basis of prevailing conditions at each point in time. On that basis, the outlook is hard-defensive, and any other stance is essentially speculative. Such speculation is fine with insignifica risk-limited positions (such as call options), but I strongly believe that investors with a horizon of less th years should limit their exposure to equities. At this horizon, even buy-and-hold strategies in stocks a

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inappropriate except for a small fraction of assets. In general, the appropriate rule for setting investmen exposure for passive investors is to align the duration of the asset portfolio with the duration of expecte liabilities. At a 2% dividend yield on the S&P 500, equities are effectively instruments with 50-year dura means that even stock holdings amounting to 10% of assets exhaust a 5-year duration. For most inves material exposure to equities requires a very long investment horizon and a wholly passive view about prospects.

Again, our approach is to align our outlook with the prospective return/risk profile we estimate at each p time. That places us in a defensive stance. Still, were quite aware of the tendency for investors to capi seemingly relentless speculation at the very peak of bull markets, and saw it happen in 2000 and 2007 our arguments for caution.

As something of an inoculation against this tendency, the chart below presents what we estimate as th optimistic pre-crash scenario for stocks. Though I dont believe that markets follow math, its striking h market action in recent years has followed a log-periodic bubble as described by Didier Sornette (see Increasingly Immediate Impulses to Buy the Dip).

A log periodic pattern is essentially one where troughs occur at increasingly frequent and increasingly s intervals. As Sornette has demonstrated across numerous bubbles over history in a broad variety of as classes, adjacent troughs (say T1, T2, T3, etc) are often related to the crash date (the finite-time singu by a constant ratio: (Tc-T1)/(Tc-T2) = (Tc-T2)/(Tc-T3) and so forth, with the result that successive trough closer and closer in time until the final blowoff occurs.

Frankly, I thought that this pattern was nearly exhausted in April or May of this year. But here we are. W important here is that the only way to extend that finite-time singularity is for the advance to become ev vertical and for periodic fluctuations to become even more closely spaced. Thats exactly what has hap and the fidelity to the log-periodic pattern is almost creepy. At this point, the only way to extend the sing beyond the present date is to envision a nearly vertical pre-crash blowoff.

So lets do that. Not because we should expect it, and surely not because we should rely on it, but bec should guard against it by envisioning the most optimistic (and equivalently, the worst case) scenario. the essential caveat that we should neither expect, rely or be shocked by a further blowoff, the followin depicts the market action that would be consistent with a Sornette bubble with the latest finite time sin that is consistent with market action since 2010.

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To be very clear: conditions already allow a finite-time singularity at present, the scenario depicted abo most extreme case, it should not be expected or relied on, but we should also not be shocked or disma occurs.

Just a final note, which may or may not prove relevant in the weeks ahead: in August 2008, just before market collapsed (see Nervous Bunny), I noted that increasing volatility of the market at 10-minute interv one of the more ominous features of market action. This sort of accelerating volatility at micro-intervals related to log-periodicity, and occurs in a variety of contexts where theres a phase transition from one another. Spin a quarter on the table and watch it closely. Youll notice that between the point where it sp smoothly and the point it falls flat, it will start vibrating uncontrollably at increasingly rapid frequency. Th phase transition. Again, I dont really believe that markets follow math to any great degree, but there ar historical examples of log-periodic behavior and phase-transitions in market action that it helps to recog these regularities when they emerge. Risk dominates. Hold tight.

The foregoing comments represent the general investment analysis and economic views of the Advisor, and ar solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section rela specifically to the Hussman Funds and the investment positions of the Funds.

Fund Notes

As of last week, market conditions have re-established the most extreme overvalued, overbought, over rising-yield condition we define. Despite a record of identifying the most extreme market peaks in histo syndromes have been largely without consequence since late-2011. As investors who focus on a full-c horizon, we continue to view these conditions with great concern, while recognizing that this run of spe need not end immediately.

Every market cycle produces conditions associated with very strongly favorable return/risk profiles. Tho conditions feature at least a moderate retreat in valuations followed by an early improvement in market Such conditions at the beginning of the bull market in early 2003 were essentially what allowed us to re

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majority of our hedges (despite valuations that were still fairly rich from a historical standpoint). The ne stress-test our return/risk estimation methods against Depression-era outcomes in 2009 and early-201 anticipating and nicely navigating the 2007-2009 decline) forced us to miss that window in the present cycle, but I do not doubt that we will observe such conditions again and again in market cycles ahead.

I also do not doubt that well over half of the recent bull market advance will be surrendered over the co of this market cycle. I don't doubt it because that amount of surrendered progress is the norm for even the-mill market cycles. It's a very bad thing, in my view, that investors have abandoned the sense to se valuations that exceed anything we observed prior to the late-1990s bubble, except for a few weeks at peak. The belief of investors that they can get out en masse when QE ends, or at some other well-defin universally anticipated exit point, is a fiction for which I cannot imagine a pleasant ending.

Strategic Growth Fund remains fully hedged, with a staggered strike position that places the strike pri index put options a few percent below present market levels. Strategic International remains fully hedg Strategic Dividend Value is hedged at about 50% of the value of its stock holdings. In Strategic Total R clipped our duration back to about 4 years about mid-week (meaning that a 100 basis point move in bo would be expected to impact Fund value by about 4% on the basis of bond price fluctuations). The Fun holds about 5% of assets in precious metals shares and about 4% of assets in utility shares. ---

Prospectuses for the Hussman Strategic Growth Fund, the Hussman Strategic Total Return Fund, the H Strategic International Fund, and the Hussman Strategic Dividend Value Fund, as well as Fund reports information, are available by clicking "The Funds" menu button from any page of this website.

Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-loo statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a g of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. A returns may differ substantially from the estimates provided. Estimates of prospective long-term returns S&P 500 reflect our standard valuation methodology, focusing on the relationship between current mar and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see f example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Deca Valuing the S&P 500 Using Forward Operating Earnings ).

Home | The Funds | Open an Account | Account Access | Research & Insight | Site Map [Open Disclosure in Separate Window] Past performance does not ensure future results, and there is no assurance that the Hussman Funds will achieve their investment objectives. An investor's shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than the performance quoted above. More current performance data through the most recent month-end is available at www.hussmanfunds.com. Investors should consider the investment objectives, risks, and charges and expenses of the Funds carefully before investing. For this and other information, please obtain a Prospectus and read it carefully. The Hussman Funds have the ability to vary their exposure to market fluctuations depending on overall market conditions, and they may not track movements in the overall stock and bond markets, particularly over the short-term. While the intent of this strategy is long-term capital appreciation, total return, and protection of capital, the investment return and principal value of each Fund may fluctuate or deviate from overall market returns to a greater degree than other funds that do not employ these strategies. For example, if a Fund has taken a defensive posture and the market advances, the return to investors will be lower than if the portfolio had not been defensive. Alternatively, if a Fund has taken an aggressive posture,
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