Comfort is Not Your Friend

"Abrupt market weakness is generally the result of low risk premiums being pressed higher. There need not be any collapse in earnings for a deep market decline to occur. Fundamentals don’t have to change overnight. There is in fact zero correlation between year-over-year changes in earnings and year-over-year changes in the S&P 500. Rather, low and expanding risk premiums are at the root of nearly every abrupt market loss."
John P. Hussman, Ph.D., July 30, 2007

The overall profile of market conditions continues to feature: 1) hypervaluation on the measures we find best-correlated with actual subsequent S&P 500 total returns, coupled with 2) continued deterioration in our measures of market internals, which are the most reliable tools we’ve found to gauge the psychological inclination of investors toward speculation or risk-aversion.

It bears repeating that valuations are remarkably informative about the prospects for market returns over horizons of about 10-12 years, but are nearly useless by themselves over shorter segments of the market cycle. Over those shorter horizons, market fluctuations are driven mainly by investor psychology. To measure that psychology, we can take advantage of the fact that investors tend to become indiscriminate when they are inclined to speculate. Speculative psychology is revealed by uniformity of market action across the full spectrum of securities and security-types, while breakdowns and divergences reveal growing risk-aversion.

Presently, we observe a particularly dangerous pairing of extreme valuations and deteriorating market internals. Coming off of one of the most extreme periods of overvalued, overbought, overbullish enthusiasm in market history, and coupled with hostile yield pressures and widening credit spreads in the debt markets, the current set of market conditions is easily among the most hostile in history.

A “risk-premium” is the extra future return, over and above risk-free investments, that gets built into the current price as compensation for accepting uncertainty. Yet in over three decades in the financial markets, I’ve rarely seen investors actually consider risk premiums directly, and those that do typically use ridiculously invalid methods (like the Fed Model) to estimate them. Most investors appear to gauge risk-premiums based on how the market has made them feel. After stock prices have already advanced for years, they imagine that risk premiums are high, and after stock prices have already collapsed, they imagine that risk premiums are low. They do this because they assess risk and return by looking backward instead of forward.

The truth is that when investors become willing to accept elevated market valuations and high stock prices, they are typically accepting very low risk premiums and future returns as compensation for accepting risk.

Conversely, when investors become fearful of depressed valuations and low stock prices, they are typically demanding very high risk premiums and future returns as compensation for accepting risk.

A market crash is nothing more than a period where low risk premiums are pushed abruptly higher. For that reason, the combination of thin risk premiums, increasing risk-aversion, and upward yield pressures is the single most negative set of conditions an investor can face. Ignore this paragraph to your detriment.

The chart below shows our own estimate of the prospective 12-year total return of the S&P 500, over and above the returns available on Treasury bonds over the same horizon. The red line shows the actual, realized risk premium of the S&P 500 over the subsequent 12-year period. From present starting valuations, the S&P 500 is likely to materially underperform even low-yielding Treasury bonds in the years ahead.