The Secret Life of Fed Pivots

Speculative bubbles collapse. I don’t know how to make that point simpler, but somehow it needs to be said. Still, attention to investor psychology – speculation versus risk-aversion – can help enormously. A market crash is nothing more than low risk-premium meeting risk-aversion. Indeed, when investors become risk-averse, they treat safe liquidity as a desirable asset rather than an inferior one, so creating more of the stuff does nothing to support stocks. That’s how the market could collapse in 2000-2002 and 2007-2009 despite aggressive and persistent Fed easing.

Pure speculative psychology is the only thing standing between a hypervalued market that continues to advance and a hypervalued market that drops like a rock. Our best gauge of that psychology – the uniformity of market internals – remains divergent enough to keep market conditions in a trap-door situation.

When investors are inclined to speculate, they tend to be indiscriminate about it, so we gauge that psychology based on the uniformity or divergence of market internals across thousands of stocks, industries, sectors, and security types, including debt securities of varying creditworthiness.

Since late-2017, we’ve refrained from adopting or amplifying a bearish outlook when we observe that uniformity. We’ve also become open to moderately constructive stances – though still with safety nets and tail-risk hedges – regardless of the level valuations, provided that market internals indicate that investors have the speculative bit in their teeth. All of this is what Ben Graham might have described as ‘intelligent speculation, kept within minor limits.’

At present, our measures of market internals remain sufficiently divergent to hold us to a strongly defensive stance. Indeed, the main headwind for hedged equity strategies in recent weeks has been the divergence between the broad market and capitalization-weighted indices dominated by overvalued large-cap glamour stocks. I expect that this bubble will end terribly, and the damage will take more than a decade to undo.

I know that many of you believe that the current episode of speculative enthusiasm will persist forever –that the Fed will make it persist. We’ve already established that market returns are likely to be flat or poor even if the market achieves what Irving Fisher disastrously projected as a ‘permanently high plateau’ in 1929, and valuations remain forever above extremes never seen before last year. Investors should also consider what might happen if valuations merely touch their historical norms – even 20 years from today – and growth in fundamentals matches that of the past 20 years. The simple arithmetic implies that the S&P 500 would actually lose value on a total return basis.”

– John P. Hussman, Ph.D., November 8, 2021, When Bubble Meets Trouble