They’ve Ruled Out Tail Risk

As of Friday, December 16, the S&P 500 Index is down -19.7% from the most speculative level of valuations in U.S. history – exceeding even the 1929 and 2000 extremes, based on the valuation measures we find best-correlated with actual subsequent market returns in cycles across history. The apparent shallowness of this loss isn’t a sign of “resilience.” Despite being nearly a year into what we expect to be a far deeper retreat, the relatively shallow loss isn’t even surprising. The same thing happened in the first year of each of the three deepest post-war stock market collapses: 2000-2002, 2007-2009, and 1973-74.

Specifically, from the March 24, 2000 bubble peak through March 9, 2001 (just under a year into that bear market, as today), the S&P 500 index lost only -19.3%. Similarly, from October 7, 2007 through September 19, 2008, in what was soon to be known as the global financial crisis, the S&P 500 lost just -19.8%. From January 11, 1973 market peak to January 2, 1974, the S&P 500 lost just -18.8%, amid a bear market that would ultimately take the stock market down by half.

The chart below presents the ratio of nonfinancial market capitalization to gross value-added. MarketCap/GVA is our most reliable valuation gauge in market cycles across history, including recent decades. Notice how little impact the 2022 market decline to-date has had on valuations. Though recent market losses have removed the most extreme speculative froth, our most reliable valuation measures remain near their 1929 and 2000 extremes.

Nonfinancial equity market capitalization to gross-value added (Hussman)

Our Margin-Adjusted P/E (MAPE) presents a similar and longer-term view.

Hussman Margin-Adjusted P/E

The spike to historically unprecedented levels at the beginning of 2022 was encouraged by Federal Reserve actions that forced the public to choke down 36% of GDP in zero-interest base money. The Fed is now paying banks 4.4% interest on this base money, which greatly reduces its speculative effect, but it must still be held by someone in the economy – mainly indirectly as personal and corporate bank balances – until it is retired by the Fed. If one bank decides to lend the money, a customer deposit is now backed by that loan instead of base money. The base money goes to the borrower’s bank and now backs that borrower’s new deposit. If the borrower puts the base money “into” stocks, the seller of those stocks takes the base money right back “out.” Somebody has to hold the stuff until the Fed retires it, and for most of the past decade, it was earning nothing. That, coupled with the direct, indirect, and likely temporary impact on profits of massive pandemic deficits, encouraged the most profoundly reckless yield-seeking speculative bubble in U.S. history.