The Music Fades Out

Chuck Prince famously said we have to dance until the music stops. Actually the music had stopped already when he said that.
– George Soros

In recent days, the combination of extreme valuations and unfavorable market internals has been joined by acute dispersion in daily trading data that often occurs within a few days of pre-collapse peaks in the market. My opinion is that the music has already quietly faded out like the end of a pop song, in a wholly uneventful way, and that even a surprise push to further highs would be marginal. Still, as a practical matter, there’s no need for opinions or forecasts about future market behavior – it’s enough to align ourselves with prevailing conditions, and to change our stance as observable conditions change.

Be careful to distinguish the level of valuations, which have been extreme for quite some time, from the consequences of overvaluation, which depend on surrounding market conditions. While valuations provide an enormous amount of information about long-term investment prospects, and likely downside risk over the completion of any cycle, the information from valuations is often entirely useless and even detrimental over shorter segments of the market cycle. The question isn’t whether valuations are useful, but when.

What governs market behavior over shorter segments of the cycle is the psychological disposition of investors toward speculation or risk-aversion, which we infer from the behavior of market internals across thousands of individual securities, as well as sectors, industries, and security-types. When investors are inclined to speculate, they tend to be indiscriminate about it. But once the “uniformity” of market internals deteriorates, and market action displays increasing dispersion, divergence, and lack of participation, it’s a rather strong signal that speculation has left the building.

When the market loses that uniformity, valuations often matter suddenly, and with a vengeance. This is a lesson best learned before a crash rather than after one.
– John P. Hussman, Ph.D., October 3, 2000