Broad-Based Overvaluation in Stocks Main Catalyst for a Possible Stock Market Crash
The man who accurately predicted the 2000 Tech Bubble and the 2008 U.S. Housing Bubble is issuing another dire warning.
John Hussman is sounding the alarm on overvalued U.S. markets, except with a twist. While other bubbles have seen frothy elements account for a large portion of expensiveness, in this bubble, everything is expensive. John Hussman’s predictions for 2017 call for a potential stock market crash to happen any time, catching unsuspected investors stuck in a hypnotic trance.
And what is the basis for John Hussman’s prediction for a stock market crash? Overvaluation, plain and simple. Extremes in consumer confidence, investor sentiment, valuation, and price extension have historically marked market tops. Hussman argues this will be no exception. It is through this prism that Hussman boldly declares today’s markets to be “the broadest market valuation extreme in history… while the median valuation of S&P 500 components is now easily at the highest level on record.” (Source: “Blue Skies,” Hussman Funds, March 13, 2017.)
There’s little question that empirical evidence is on his side.
Consider that in today’s world, it’s becoming an anomaly when stock markets around the globe aren’t breaking new records weekly. Buoyed by a torrent of liquidity brought about by record-low interest rates and monetary easement, the S&P 500 has almost tripled since its February 2009 lows. NASDAQ has done even better, rising almost 400% in that time. ETF inflows have smashed records, as retail investors have gone all-in.
There hasn’t been a meaningful correction—defined as a market which has declined 20% or more from peak to trough—since 2011. And even then, it barely broke through before markets resumed their unrelenting march forward.”Historic,” “awe-inspiring,” and “once-in-a-lifetime,” are all apt descriptions on market performance since 2009.
With facts such as these, it’s little wonder that Hussman believes that investors are also failing to recognize the euphoria bubble gripping the market. The metaphorical “wall of worry” is not only being scaled repeatedly; it’s being destroyed by 500 pounds of TNT. Literally every piece of bad news is being treated as a buying opportunity. And it’s not just a mundane mass of “soft data” indicators, but meaningful metrics which should move markets in a negative direction. Again, Hussman contends this is symptomatic of market tops.
Despite this, Hussman explains that this exuberance is to be expected. That’s because low interest rates will fuel any market bull indefinitely, no matter how telegraphed or irrational it becomes. Zero-interest policies are so powerful that market internals have to crumble drastically before even thinking the market has topped. We may be reaching that point soon.
As supporting evidence, Hussman references surging consumer confidence as proof of market euphoria. The index is resting at 10-year highs, levels not seen until just before the U.S. housing crash. It also mirrors the performance of the S&P 500 in lockstep, which it has tended to do historically. Essentially, when investors feel good about the economy, they invest in the market. The numbers bear this out.
If we look at market performance in the months where the consumer confidence index is at its lowest, the 12-month return averages a robust 11.9%. Following a select number of months when readings were at their highest, the 12-month return is just three percent. Given this data, it appears that consumer confidence plays a direct role in market return expectations over time. This makes it a reliable indicator of index tops, arguably where we are today.
|Dow’s Time Period Return||Following 10% of Months with Lowest CCI Reading||Following 10% of Months with Highest CCI Reading|
(Source: “Why soaring consumer confidence should worry investors,” MarketWatch, March 30, 2017.)
Given that Hussman sees a bubble in both consumer confidence and broad valuations, which have bested any previous bubble, his models are sounding the alarm. As we all know, consumer confidence is fragile. It would take much less than a serious negative catalyst like a regional World War 3 or rising national debt leading to a credit downgrade to shatter it in this cycle.
In the end, irrational consumer sentiment leading to over-exuberance is a movie we’ve all seen before, and it never ends well. All that’s left to ponder is whether the next recession brings about Great Depression-like conditions, or more traditional three or four quarters of relatively shallow negative GDP values.
With the Federal Reserve’s hands all but tied due to already-low interest rates and bloated balance sheets, no one should be surprised if it’s the former.
Are These Frothy Valuations Justified?
According to Hussman, this broad-based overvaluation is presenting a new kind of danger rarely seen before. Unlike past bubbles—with the possible exception of the landscape preceding the stock market crash of 1929—this overvaluation is not limited to a specific sector or class. Almost every sector is trading significantly above long-term historical medians. While specific stock classes raised all boats in other bubbles, broad-market valuations as a whole were still defensible and historically contained. This is not the case today.
For example, in 1999 you could argue that the Internet would make all businesses more efficient through more effective supply chains and payments processing, leading to increased earnings. Investors recklessly bid up companies directly involved with the Internet, but it stood to reason that all companies would benefit in some capacity. And they did. Thousands upon thousand of companies eventually made use of the Internet to streamline operations, improve processes, and reduce headcount. We can say in hindsight that the stock market levitation leading up to 2000 was actually justified—just not in Internet stocks themselves, with price-earnings (P/E) ratios pushing 200. Although the Internet under-delivered on its earnings promise to those directly involved, it exceeded expectations with everyone else.
John Hussman’s stock market outlook for 2017 is telling us that this market is different. Certain factors are conspiring to create ongoing levitation in the markets, and this is blinding even the most battle-tested veterans. The situation is particularly dangerous when you consider there will be literally no place to hide once the stock market crash hits, as there are few “undervalued” equities.
Another thing to consider is the topic of expensive markets versus markets that will catch up. Wall Street has been expecting breakout earnings results for several years, however, earnings have fallen flat. While the S&P 500 is on the precipice of more records, earnings are flat. Hence, almost the entirety of stock market price expansions has to do with expanding valuations as opposed to real earnings growth. That’s the problem that Hussman is warning us about.
But all good things come to an end. It’s just the way it works. The winners will recognize that the good-getting has ended, and will adopt a protective stance to preserve their newfound wealth. The losers will continue to press their luck until they get caught in a market event, and their fate is decided for them.
John Hussman Predictions for 2017
Just because Hussman is bearish on the market doesn’t mean the John Hussman portfolio is devoid of popular equities in tech or industrials. While he’s been bearish much of the past two decades, he’s not considered a “permabear” like some other analysts. Hussman’s net worth in today’s climate is skewed towards defensive offerings, at least until this pervasive overvaluation works itself out.
Hussman’s stock market outlook for 2017 is telling us that this market is different. In his words, “The most negative market outcomes generally emerge when overextended valuations are joined by early deterioration in market action.” (Source: Hussman Funds, op cit.)
Given that these conditions are present in the market, where do we go from here? Hussman’s answer isn’t that precise; he tends to stay clear of exact timelines and focuses on what conditions could yield. However, it’s clear he expects a very bearish reversal in the near future; one that could have a devastating impact on individual portfolios.
In fact, in his market commentary, he notes that it’s important to “allow for near-zero 10-12 year S&P 500 total returns and a likely interim loss on the order of 50-60%.” He acknowledges that valuation metrics are poor short-term indicators of market performance; they become more reliable as time passes. (Source: Ibid).
In the end, twice-right Hussman correctly called the Tech Bubble top, as well as the U.S. housing collapse. Both times his proprietary models were screaming that the market was overvalued by sizable levels, and would revert back to the mean. His predictions proved prescient on both occasions. Could he be right a third time? It’s quite possible, and more market experts comment of the unsustainability of the market.
My stock market predictions mimic many of the undertones laid out by John Hussman. I believe that the market is seriously overvalued in a broad-based way, making conditions particularly susceptible to a stock market crash. But I also believe that the risk of “trigger” scenarios out there is higher than it’s ever been. One of these scenarios will resonate with the market, sending it careening lower.
Despite the warnings, most investors believe they can exit before the stock market crash. The problem is, when you’re conditioned to buy the dip month after month, year after year, when that one dip comes that doesn’t go back, investors get trapped.
If Hussman is correct, that dip is coming, and it best be avoided.