Saturday, October 03, 2015

The Bear Has Awakened

By Jim Quinn

“Every man has a right to his own opinion, but no man has a right to be wrong in his facts” ― Bernard M. Baruch

As the market drops 200 to 300 points daily on a fairly frequent basis these days, and has now dropped 13% in the last four months, John Hussman’s valuation analysis based upon historical facts is proving to be accurate. He’s not an “I told you so” type of person, but I am. The MSM stories follow the same old storyline – this is just a correction, time to buy the dip, stocks are undervalued, the Fed won’t let the market fall. We’ve been here before, twice in the last fifteen years. Wall Street and their media mouthpieces attempted to spread misinformation about the nature of the markets in 2000 and 2007, as epic bear markets were just getting underway. John Hussman cut through their crap then and he is cutting through it now:

“Is our profession really so lazy that we would advise people to risk their financial security based on tinker-toy models and pretty pictures that we don’t even have the rigor to test historically? Investors appear eager to ‘scoop up’ so-called ‘bargains’ on the belief that stocks are ‘cheap relative to bonds.’ All of this is predicated on the belief that profit margins will remain at record highs, that the Fed Model is correct, and that P/E ratios based on extremely elevated measures of earnings should be evaluated based on norms for much more restrained measures of earnings. Based on daily closing prices, the S&P 500 has not even experienced a 10% correction, yet the recent decline has been characterized as if investors are acting ‘like the world is about to end.’ This is not the pinnacle of human irrationality, but in fact, quite a shallow selloff from a historical standpoint. The fact that Wall Street is branding it otherwise is evidence that investors have completely forgotten how deep the market’s losses can periodically become.”

Hussman Weekly Market Comment, August 2007

Long-Term Evidence on the Fed Model and Forward Operating P/E Ratios

“Given the damage already wrought on the Nasdaq, there is a natural inclination to buy the dip. We believe that there is little merit in doing so. The current market climate is characterized by extremely unfavorable valuations, unfavorable trend uniformity, and hostile yield trends. This combination is what we define as a Crash Warning, and this climate has historically occurred in less than 4% of market history. That 4% of market history includes the 1929 crash and the 1987 crash, as well as a number of less memorable crashes and panics. We prefer to hedge until there is a rational prospect for market gains. When valuations are favorable, stocks are attractive from the standpoint of ‘investment’ – meaning that stock prices are attractive compared to the conservatively discounted value of cash flows which will be thrown off in the future. When trend uniformity is favorable, stocks are attractive from the standpoint of ‘speculation’ – meaning that regardless of valuation, investors are displaying an increased tolerance for risk which favors a further advance in prices.”

Hussman Investment Research & Insight, November 2000

The Dow has dropped 2,300 points with no particular event responsible. The Fed has continued to delay their perennially imminent interest rate increase, six years into a supposed economic recovery. Bernanke declared he would raise rates when unemployment reached 6.5%. According to BLS propaganda, that happened sixteen months ago. The Fed will not be coming to the rescue. Their credibility is shot. This correction is just the beginning. As Hussman points out, this market is still overvalued and primed for a vertical drop. The collapse of Glencore and their $18 billion derivatives book seems like as good a trigger as any.

If there is a single pertinent lesson from history at present, it is that once obscenely overvalued, overvalued, overbullish market conditions are followed by deterioration in market internals (what we used to call “trend uniformity”), the equity market becomes vulnerable to vertical air-pockets, panics and crashes that don’t limit themselves simply because short-term conditions appear “oversold.”

When you tell people in self denial the market could drop 40% in a few months, they think you are crazy. They declare this could never happen. They would get out of the market before it would fall vertically. Their memories are conveniently short as their normalcy bias and cognitive dissonance blind them to what happened over three months in 2008/2009.

So here’s an interesting question: how quickly, historically, have valuations tended to mean-revert? The answer is a bit tricky, because it depends on the condition of market internals. If valuations are elevated and market internals are unfavorable, valuations can retreat vertically. In 2008, for example, the market went from steep overvaluation to slight undervaluation within the span of three months, losing over 40% of its value. On the other hand, rich valuations have periodically been sustained for long periods of time, as they were in the late-1990s and in recent years, because investors stayed in a risk-seeking mood, as evidenced by uniformly favorable market internals.

Now for the really bad news. When markets are extremely overvalued, reversion to the mean requires a long period of undervaluation. They call this a secular bear market. We had one from 1966 to 1982. This one began in 2000 and will likely extend into the early 2020’s. We’ve now had two cyclical bear markets and one cyclical bull market within this secular bear market. Secular bear markets end with extremely low valuations (PE ratios of 10, Price to Book values under 1.0, Price to Sales ratios under 1.0). We are a long long way from the bottom of this secular bear.

What the historical evidence shows is this. First, the overvaluation or undervaluation of the market, on reliable measures, is generally “worked off” over a period of about 12 years, on average. That’s mean-reversion, but that’s not where the process ends. Rather, the valuation extremes of the market tend to be fully inverted over a horizon of about 18-21 years; ending with extremes of the same degree but in the opposite direction. That’s what we’ll call “mean-inversion.” Statistically, a period of somewhere close to two decades has typically stood between the wildest exuberance and the deepest despair on Wall Street, and vice-versa.

While the concept of mean-inversion seems strange – almost preposterous – it actually aligns very well with what we know about so-called “secular” market phases. Specifically, we can describe a “secular bull market” as a period that comprises a number of individual bull-bear market cycles, typically reaching successively higher valuations at the peak of each bull market advance. Conversely, a “secular bear market” comprises a number of individual bull-bear market cycles, typically reaching successively lower at the trough of each bull market decline. These “secular” bull and bear phases are each commonly recognized as lasting somewhere about two decades.

As usual, and expected, the perennial bulls working on Wall Street and blathering on the boob tube, care not a wit for history, facts, or the truth about markets. They are driven by emotion. Greed and fear alternate as human beings never change. We don’t improve over time. Our arrogance, hubris and delusional thinking always bite us in the ass. John Hussman provides the lesson, but the students aren’t paying attention. They are focused on the latest tweet or new social media IPO.

Following the panic of 1908, the stock market enjoyed total returns averaging 14% annually until the 1929 peak. The culmination of that advance was a 9-year period when stocks enjoyed total returns averaging nearly 26% annually. The most memorable secular bear period in U.S. history then began, running from 1929-1949. During those two decades, the S&P 500 would turn in a nominal total return of less than 1% annually, including an interim loss approaching 90%, and a negative real return overall. That period was followed by a secular bull phase from 1950-1965, during which the S&P 500 turned in a nominal total return of about 17.5% annually. The secular bear period that followed from 1965-1982 again left investors with a negative real return after inflation. The 1982-2000 advance represented a classic secular bull market period, and produced a total return for the S&P 500 averaging 20% annually. By the 2000 peak, valuations were so extreme that reliable valuation measures accurately projected negative total returns on a 10-year horizon (as we estimated at the time). The nominal total return of the S&P 500 since the 2000 peak has averaged just 3.5% annually, but even that gain is entirely due to the fact that valuations have again been pushed to offensive extremes. We fully expect that entire total return to be wiped out over the completion of the current market cycle. Doing so would not even bring the most reliable valuation measures back to their historical norms.

Remember the good old days of 2000? Budgets were practically in balance. Over 67% of working age Americans had a job. There were no American initiated wars raging in the world. The stock market was reaching new highs. Since 2000, the country has essentially been in recession, despite the fake economic propaganda peddled to the masses. The stock market peak was the end of the secular bull market. The market will need to drop by approximately 70% to reach its secular low. That can happen rapidly over the next couple years or drag on for another 5 to 7 years. But it will happen.

The beginning and end of secular phases are generally identified on a valuation basis, not on a price basis, so we continue to view the most recent secular peak as being 2000, even though prices are higher today.

The 2009 low is often discussed as a “secular” valuation trough. It didn’t even come close. While I did emphasize after the 2008 plunge that stocks had become undervalued relative to historical norms, remember that valuations similar to the 2009 trough were followed, in the Depression, by a further two-thirds loss in the value of the stock market. The market would have had to decline by an additional 50% to match the valuations observed at prior secular lows. I’ve regularly detailed the challenges that followed from my insistence on stress-testing our methods against Depression-era data, and how we fully addressed them in mid-2014. We don’t require anything near valuation levels of 2009, much less 1974 or 1982, in order to encourage a constructive position – provided that we observe an improvement in market internals. But investors shouldn’t kid themselves into thinking that some 18-20 year “count” began in 2009 from which many more years of advancing prices should follow, despite obscene valuations that already eclipse those of 1907, 1929, 1937, 1965, 1972, 1987, and 2007.

If there’s any “count” to be considered, investors might consider the one that began at the 2000 peak. They might also consider that the market peak in May of this year reached valuations more extreme than we observed at the beginning of every secular bear phase except 2000. The good news here is not only that secular bear markets contain a series of individual cyclical bull market advances, but also that the low of a secular bear, from a price perspective, has typically occurred earlier than the low from a valuation perspective (for example, the lowest price of the 1965-1982 secular bear was actually in late-1974).

I wonder how many willfully ignorant investors can handle a 50% to 70% haircut in their 401k, especially if they are over 50 years old. I wonder how many people still trust Jim Cramer and the Wall Street muppet fleecing machine to tell them the truth about the markets. The saddest part of this entire Federal Reserve created debacle is there is no place to hide. Bonds yielding 2% will provide a negative real return over the next ten years. Real Estate is at least 30% overvalued nationally, and as much as 60% overvalued in hot markets like San Francisco, Miami and NYC. The bear market will ravage all markets. I wonder how much angrier the populace will become when the current recession results in more job losses, bankruptcies and revelations of Wall Street malfeasance. Beware of the bear.

Read more Jim Quinn.

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