Questions We Hear a Lot

While we don’t presently observe conditions to look for a ‘buying opportunity’ or a ‘bottom’ from a full-cycle standpoint, we do observe conditions that are permissive of a scorching market rebound, even if it only turns out to be the ‘fast, furious, prone to failure’ variety. We wouldn’t dream of removing our safety nets against a market decline that I continue to expect to draw the S&P 500 toward the 1000 level by the completion of this cycle. Still, we’ve prepared for the possibility of unusual volatility here, most likely including one or more daily moves in the range of 4-6%, potentially to the upside. Yes, that means one or more daily moves on the order of 100-150 points on the S&P 500 and 900-1300 points on the Dow. You think I’m kidding.”

– John P. Hussman, Ph.D., Interim comment, Pre-open, 12/26/18

In recent days, we’ve heard a number of analysts gushing that the S&P 500 is vastly cheaper than it was only a few months ago. It’s worth noting that they’re actually referring to an index that is now less than 10% below the steepest speculative extreme in history. The chart below puts current valuations into perspective, using our Margin-Adjusted P/E, which is better correlated with actual subsequent 10-12 year market returns than the price/forward operating earnings ratio, the Shiller CAPE, the Fed Model, and a wide range of alternative valuation measures that Wall Street uses to reassure investors that valuations are anything less than obscene.

As market conditions currently stand, valuations remain extreme and market internals remain negative. So aside from the likelihood of a knee-jerk market spike on any variant of the word “deal,” we continue to be in a trap-door situation with respect to market risk. Though we did take the edge off of our negative outlook to allow for a scorching relief rally, my present view is that the overall function of that relief rally has been served.

Still, it’s important to be clear – and this point is central to the adaptation that we made to our approach back in 2017 – if our measures of market internals were to improve, signaling a shift of investor psychology away from risk-aversion and toward speculation, we would expect to adopt a constructive market outlook, though undoubtedly with a safety net given present valuation extremes. There’s still too much divergence across individual securities, industries, sectors, and security-types to identify that sort of shift here, but we can’t rule it out. We’ll take that evidence as it comes.

What I can say, unequivocally, is that at points where our measures of market internals become favorable, we will not adopt or amplify a negative market outlook, regardless of how extreme market valuations may be. We learned the hard way in this half-cycle that we can no longer rely on any limit to the recklessness of Wall Street once speculators get the bit in their teeth. Again, safety nets would be essential in any event, but if internals shift, so will our outlook.