How to Needlessly Produce Inflation

"I’ve noted over the years that substantial market declines are often preceded by a combination of internal dispersion, where the market simultaneously registers a relatively large number of new highs and new lows among individual stocks, and a leadership reversal, where the statistics shift from a majority of new highs to a majority of new lows within a small number of trading sessions."
-John P. Hussman, Ph.D.
Market Internals Go Negative, July 30, 2007

What distinguishes an overvalued market that continues to advance from an overvalued market that often drops like a rock? In my view, it’s the psychological disposition of investors toward speculation or risk-aversion. Though investor psychology seems abstract and intangible, it can also be inferred from market action. Speculation tends to be indiscriminate, and the strongest market advances are typically also the broadest. In contrast, risk-aversion gradually reveals itself in divergences, dispersion, and eventually ragged market action and disorder.

As a result, we find that the best measure of that investor psychology is the uniformity or divergence of market action across thousands of individual securities, industries, sectors, and security-types, including debt securities of varying creditworthiness. I use the word “market internals” to describe the signal we extract from their joint behavior across multiple facets, including trend, momentum, trading volume, leadership, yield spreads, breadth, participation, and other metrics.

Two weeks ago, I posted a special interim update to our website and mailing list, They’re Running Toward the Fire, noting “Presently, we observe market conditions that have been associated almost exclusively, and in most cases precisely, with the most extreme bull market peaks across history.”

That concern reflects not only hypervaluation on the measures we find best correlated with long-term market returns, but also unfavorable market internals, the emergence of single most extreme “overvalued, overbought, overbullish” syndrome we identify, and features of breadth (advancing issues vs. declining issues) and leadership (new highs vs. new lows) that often accompany market extremes.

Market valuations have been extreme for a long time. While valuations have enormously important implications for long-term market returns and full-cycle market risks, valuations are not a timing tool. Indeed, it’s impossible for the market to reach hypervalued levels without persistently advancing through lesser extremes. It’s the combination of extreme valuations, plus unfavorable market internals (indicating a shift among investors from speculation toward risk-aversion), plus extreme overextension, plus dispersion and reversals in leadership, that create a volatile mix.

A quick review of these conditions will suffice. The following chart shows our Margin-Adjusted P/E for the S&P 500 Index, which is better correlated with actual subsequent market returns than a wide range of alternatives, including price/forward-earnings, the Shiller cyclically-adjusted P/E (CAPE), and the so-called Fed Model (the S&P 500 forward earnings yield vs. 10-year Treasury yields).