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Investing

Visual Summary: John Hussman’s Case for a Market Crash

John Hussman of Hussman Funds is pretty bearish. Others are bullish. But I think it’s investing best practice to listen to both the optimists and pessimists. Only then can you approach the markets with a balanced perspective.

In his most recent market commentary, Hussman makes several points that shouldn’t be ignored. His most recent commentary is quite long, so I’ve provided a visual summary of his key points and charts below:


Valuations are at record highs for all stocks (not just an especially expensive segment of the market). The chart below shows price-to-revenues broken down by decile. Across the entire range of valuations, all segments are at record price-to-revenue ratios.

S&P 500 median price-revenue ratios by valuation decile

The same is true when breaking down the market by market capitalization. Small, medium and large cap stocks are all trading at record valuations.

S&P 500 median price-revenue ratio by market capitalization

Companies with negative earnings in particular have skyrocketed in valuation. This speaks to investor focus on the future. Unfortunately, expectations – like during the Internet bubble – often go unrealized, and lofty valuations eventually fall back to Earth.

Goldman Sachs non-profitable technology basket

As an investment strategy, hope is prevalent in the IPO market too. New issues – such as the recent Bumble IPO, which jumped 64% on the day of listing – shoot to the moon. Yet, many of these companies barely have any earnings (or even revenues in many cases) to speak of. Again, investors are flocking to IPOs in the hope of profiting off massive future potential.

Renaissance new issues index

Investors are so confident in the future they are willing to borrow to place their bets. Accordingly, margin debt as a proportion of GDP is at record levels! Borrowing to invest is a risky strategy. While one can profit handsomely investing other people’s money during a bull market, once asset prices turn it can lead to poverty. Moreover, the collective level of margin debt tends to exacerbate market declines as investors clamor to liquidate at the same time.

Margin debt to GDP

The US stock market capitalization is at record highs relative to US GDP. The value of companies relative to the value of what they produce has risen immensely.

Total equity market capitalization to GDP

Perhaps these charts don’t concern you because you’re a ‘long-term’ investor. Well, they should.

Valuations tend to be a pretty good predictor of future returns. The chart below maps Hussman’s estimated 12yr forward returns against actual forward 12yr returns – you can see the fairly tight relationship. Currently, Hussman’s model is forecasting a forward annualized 12yr return of -2.15%. Yes, negative. And yes, it is possible that long-term returns are negative because it has happened before. Moreover, historical periods of negative long-term returns tend not to be graceful and orderly. Rather markets violently oscillate between upward momentum and downward spirals.

Estimated 12-year total return for a passive 60/30/10 portfolio allocation (Hussman)

Is Hussman right this time? I don’t know. Nobody can predict the future. And the future doesn’t have to look like the past. So who’s to say that valuations don’t stretch even further? Or that revenues and earnings climb rapidly to close the valuation gap?

I don’t know. You don’t know.

But what I do know is that history shows the risks are real. Hussman is observing rhe signposts.

I’m not arguing there will be a crash tomorrow. Yet, the probability of one grows as valuations are stretched and investors gain confidence.

My suggestion to all investors is to keep your confidence in check. If you start to feel highly confident in your investing prowess you may be taking on too much risk. Great declines are often preceded by great hubris. Be aware of your own behavioural biases and remind yourself that investing in stocks could mean losing 50% of your money at any point in time. And no, you’re not good enough to get out at the right time.

If Hussman’s market return projections are right, individual investors will perform far worse. Most investors tend to plough more money into investments near market peaks and withdraw money near market bottoms, experiencing all the downside and missing out on upside.

Consequently, most investors could have real world experiences far worse than -2.15% annualized over the next dozen years.

Read John Hussman’s full commentary.

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Investing

Chart: Market Recovery vs Past Bear Markets

The coronavirus crash was fast and sharp. It recovered within months – the best recovery when compared to past bear markets.

The speed of the recovery is likely due to the speed and volume of Federal Reserve support, which exceeded all previous monetary stimulus programs.

Some argue that the massive volume of support indicates we are approaching the end game for the credit based system. Others suggest the Fed has learned from previous policy mistakes – namely, underestimating the required magnitude of stimulus. Perhaps if the Fed were more decisive in 2008/2009, the post-GFC recovery wouldn’t have taken so long.

Honestly, there are great arguments either way. I don’t know. But what I do know is the US dollar remains the reserve currency by a wide margin and its status has not been compromised by the recent monetary stimulus. This tells me that the demand for dollars more than makes up for the additional supply.

Some suggest we are in the middle innings of a secular bull market that began around 2014 or so, led by emerging technologies in cloud computing, automation, artificial intelligence and machine learning. Looking at previous market cycles, this is quite possible. In hindsight, we can see that the 2000-2012 period was essentially a sideways market. During that time the S&P 500 price level went nowhere, and it is exceedingly rare that a 12yr consolidation would be followed by another one. It’s more likely a 12yr consolidation would be followed by a secular bull market.

Of course, on a total returns basis the post-2000 experience wasn’t as bad. When including reinvested dividends, the S&P 500 broke even by 2006.

Maybe we’re in a secular bull market. Maybe we’re not. As a dumb and lazy investor I’d rather not try to time the market. Instead, I feel more comfortable, regardless of the market environment, if I own a diversified assortment of businesses that are 1) reasonably valued, 2) will survive the test of time, and 3) reward shareholders with growing dividends and share buybacks.

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Investing

Why is The Market At All Time Highs?

Many people right now are wondering why the stock market is at all time highs while the economy is in recession. I too wondered if this were an anomaly created by excessive Fed printing. So I looked to see if something similar has happened before.

As it turns out, during the 1981-1982 recession, the stock market (blue line in chart below) hit an all-time high after recovering from significant losses.

During the 1981-1982 recession, the return to stock market all time highs occurred close to the end of the recession as unemployment (maroon line) peaked.

Of course, the end of the 1981-1982 recession was only known later in hindsight, so people likely asked the same questions they are today. What they could not see was that the market approached all-time highs because the recession was close to ending. While the transition to growth was slow and painful – as I expect it to be today – with unemployment taking years to return to normal, the markets rallied once economic growth resumed.

The return to growth (second chart below) in 1982 is easily identified by unemployment (maroon line) beginning to fall and Industrial Production (blue line) starting to rise (second chart below). This occurs right near the end of the recession, as indicated by the grey shading.

Industrial Production is a great indication of economic recovery. As you can see (if you have good eyesight) in the chart below is that at the end of every recession (grey shading) Industrial Production immediately grew. The second chart below zooms into the current recession. It is clear that Industrial Production has started to grow once again while unemployment has started to trend down. This indicates the current recession likely ended in April or May and growth has resumed, explaining the stock market’s return to all time highs. (Note the entire period is shaded until the recession’s end is officially retroactively declared months later.) Again, this growth doesn’t feel like growth because we’re rebuilding from an uncomfortable bottom, but the market only cares that things are growing.

The 2020 recession was sharp, deep and short. Markets reacted accordingly and crashed faster and deeper than ever before. The recovery will be long and painful, but we are back on the growth path. Markets sniffed this out months ago explaining the rally. Markets hit all-time highs in 1982 – when unemployment was near its peak. The same thing is happening today.