Air Pockets, Free Falls, and More Cowbell

There are certain features of valuation, investor psychology, and price behavior that emerge, to one degree or another, when the fear of missing out becomes particularly extreme and the focus of speculation becomes particularly narrow. We’ve suddenly hit a motherlode of those conditions. Emphatically, this is not a forecast. It’s a statement about current, observable conditions. Not a 'limit.'Not a market call. Just sharing what we’re seeing. Still, it’s fair to add that we’ve never seen such a thing,"' John P. Hussman, Ph.D., Motherlode, November 20, 2021.

There is a particular “setup” that we’ve historically found to be associated with abrupt “air pockets” and “free falls” in the S&P 500. It combines hostile conditions in all three features most central to our investment discipline: rich valuations, unfavorable market internals, and extreme overextension. The last time we observed this combination to a similar degree was in November 2021, shortly before the S&P 500 lost a quarter of its value. The S&P 500 remains lower than it was then. Despite enthusiasm about the market rebound since October, I remain convinced that this initial market loss will prove to be a small opening act in the collapse of the most extreme yield-seeking speculative bubble in U.S. history.

The present combination of historically rich valuations, unfavorable internals, and extreme overextension places our market return/risk estimates – near-term, intermediate, full-cycle, and even 10-12 years, at the most negative extremes we define.

It’s difficult to discuss extremes like this without sounding like one is “calling a top,” so I’ll repeat what I emphasized in late-2021:

“Emphatically – and this is important – my intent here is not to ‘call the top’ of this bubble. Yes, this is a bubble in my view. Yes, I believe it will end in tears. Yes, the price investors pay for a given stream of future cash flows is inseparable from the long-term returns they can expect. Yes, if this bubble is ever to actually have a top, this would be a perfectly reasonable moment to expect one. Still, my present intent is simply to share what we’re observing.”

Let’s examine these three elements in turn – valuations, internals, and overextension.