In the Arithmetic of Risk, Hussman posted the above chart. I added the anecdotes regarding where we are. Here are some pertinent snips.
At present, I view the market as a “broken parabola” – much the same as we observed for the Nikkei in 1990, the Nasdaq in 2000, or for those wishing a more recent example, Bitcoin since January.
Two features of the initial break from speculative bubbles are worth noting. First, the collapse of major bubbles is often preceded by the collapse of smaller bubbles representing “fringe” speculations. Those early wipeouts are canaries in the coalmine.
In July 2007, two Bear Stearns hedge funds heavily invested in sub-prime loans suddenly became nearly worthless. Yet that was nearly three months before the S&P 500 peaked in October, followed by a collapse that would take it down by more than 55%.
Observing the sudden collapses of fringe bubbles today, including inverse volatility funds and Bitcoin, my impression is that we’re actually seeing the early signs of risk-aversion and selectivity among investors. The speculation in Bitcoin, despite issues of scalability and breathtaking inefficiency, was striking enough. But the willingness of investors to short market volatility even at 9% was mathematically disturbing.
See, volatility is measured by the “standard deviation” of returns, which describes the spread of a bell curve, and can never become negative. Moreover, standard deviation is annualized by multiplying by the square root of time. An annual volatility of 9% implies a daily volatilty of about 0.6%, which is like saying that a 2% market decline should occur in fewer than 1 in 2000 trading sessions, when in fact they’ve historically occurred about 1 in 50. The spectacle of investors eagerly shorting a volatility index (VIX) of 9, in expectation that it would go lower, wasn’t just a sideshow in some esoteric security. It was the sign of a market that had come to believe that stock prices could do nothing but advance, and could be expected to do so in an uncorrected diagonal line.
I continue to expect the S&P 500 to lose about two-thirds of its value over the completion of the current market cycle. With market internals now unfavorable, following the most offensive “overvalued, overbought, overbullish” combination of market conditions on record, our market outlook has shifted to hard-negative. Rather than forecasting how long present conditions may persist, I believe it’s enough to align ourselves with prevailing market conditions, and shift our outlook as those conditions shift.
Recall that the S&P 500 registered negative total returns for a buy-and-hold strategy during the nearly 12-year period from March 2000 until November 2011. I expect a similar consequence to emerge from current extremes.
The 2000-2002 collapse wiped out the entire total return of the S&P 500 – in excess of Treasury bill returns – all the way back to May 1996. The 2007-2009 collapse wiped out the entire total return of the S&P 500 – in excess of Treasury bill returns – all the way back to June 1995. We correctly anticipated the extent of both collapses. Frankly, I expect that the completion of the current cycle will wipe out the entire total return of the S&P 500 – in excess of Treasury bills – all the way back to roughly October 1997. That outcome would not even require our most reliable measures of valuation to revisit their historical norms.
You’ll often hear risk being equated with return on financial television. The proposition takes various forms. “Higher risk means higher return” or “Well, you can only expect higher returns by taking more risk.” In my view, the idea that higher risk means higher expected return is one of the most dangerous and misunderstood propositions in the financial markets. The reason it’s dangerous is that it ignores the central condition: “provided that one is choosing between portfolios that all maximize expected return per unit of risk.”
See, one of the most conventional “risky” assets investors can choose is the S&P 500. But by our estimates, that asset is priced at a level that’s consistent with negative 10-12 year total returns. Given that expected return, the S&P 500 would be largely excluded from an “optimal portfolio” on that time horizon, unless there was something else in the portfolio with a very high expected return that was negatively correlated with the S&P 500 (in which case, the S&P 500 might be included in order to reduce portfolio volatility). Here and now, it’s very true that the S&P 500 is a risky asset, but it’s madness to imagine that adding more of it to a portfolio will increase expected return, except for investors with very long horizons.
Lost in the Pictures
As usual, Hussman supplied a large number of images to support his view. In this case, Hussman supplied eight images of dot plots, mean reversions, CAPE, and other things.
He also provided Geek-analysis such as “Taking all this together, our rough estimate of average annual total returns over the coming 5 years will be: = (1+growth)(endingPE/startingPE)^(1/years)+(0.6/startingPE + 0.6/endingPE)/2–1 = (1.06)*(15/20)^(1/2)+(.03+.04)/2–1 = -4.7% annually.”
I don’t disagree with a word of that. And his images are excellent. But is the message lost in the pictures?
That’s why I stripped out what I think are the key paragraphs on risk, volatility, bitcoin, and history.
Either way, Hussman wrote another excellent article. But it will be ignored. Mathematically his message must be ignored, in aggregate. Someone has to hold every stock and every bond, at the top and all the way down.
On an individual basis, however, there are choices. So think about those key paragraphs and act accordingly.
Mike “Mish” Shedlock
Like patriotic Americans, Canadians need to fight the Collectivist agenda, or risk being swallowed up by the govt black hole. Investors are voting with their wallet.
link to armstrongeconomics.com
I’m not that young haha
Realist, so you don’t think Canadian housing market is in a bubble?
I do like the Canadian medical system even though I’m young and strapping. As well, Realist I give you props for your last argument.
i sense a straw may soon render the camel unable to carry its (debt) load…
fact #3: 15 million consumers have only medical debt on their credit reports
fact #2: 52 percent of all debt on credit reports is from medical expenses
fact #1: 43 million Americans have overdue medical debt on their credit reports
i just finished a mandated fcra training which stated a few facts from a study published 3+ years ago: link to files.consumerfinance.gov
True, if you accept statistics without critical thought then, yes, 68% is a majority and the housing industry is robust. Now with reading Mish, I would expect a certain amount of skepticism. Statistics are manipulated and are questionable. If 4 out of 10 (40%) can’t come up with $200, how does that balance with 68% home ownership?
Realist, forgive me for saying so but saying I’m not very Canadian and not polite is childish. If you don’t know 68% is down from 2011 when it was 69% and what about the 32% who don’t own a home or those in the 68% who can’t afford it but shadow banking allows them like the subprime debacle in the US. Affording (unattainable) also means not having to use creative accounting and shadow banking to buy.
link to business.financialpost.com
“Canadians can’t stop using their homes as piggy banks with line of credit debt jumping to record $230 billion”
What happens when there is a correction? Oh wait, I’m assuming housing prices are out of line.
link to business.financialpost.com
“Canadians are the most indebted in the world, OECD says, as it warns on rising debt risk”
Canada is doing just fine thank you very much
link to globalnews.ca
“In B.C., 4 in 10 people say they’re $200 away from not being able to pay the bills: survey”
It’s ok because The Realist says so
Do you even live in Canada? The debt to income ratio increases every month. In BC housing is 40%+ of GDP, which is INSANE. You don’t own something that is funded by debt during a bubble. Funny how someone who doesn’t even live here is willing to tell me I don’t know anything.
AWC said: “Read somewhere, not sure if it’s true, that Vanguard holds 7% of the S&P.” When I looked at this last April after Vanguard was reported to have $4.2 trillion under management, I calculated that the total bond market and total stock market combined had a value of approximately $69 trillion at the time, so Vanguard’s share was then about 6.1% of the combined market of stocks and bonds. The sellers of these things will find their buyers, but mostly nearer the bottom.
When you’re deep in debt, and the lender decides to raise the rates, what are your options?
Dumb question: how can “interests rates move upward” if no one can afford them to?
Most, if not all, of the industrialized world’s economy is based on issuing and rolling over debt at very low interest rates. Watch out when interest rates move upward. It won’t be pretty. Ouch.’
I agree with you 100%. Your post is brilliant!! Well done
close eye on.
Cheers Ambrose. I used to read the Daily Telegraph and AEP until it went down the toilet. I note AEPs done an article on Hong Kong. Prof Steve Keen’s (a Minsky devotee) done some excellent work on Hong Kong’s private sector debt bubble. One to keep a clse
Socialist policies always lead to wage stagnation. “cheer up, he said, things could be worse, so I cheered up, and sure enough, things got worse”. The only political answer to wage stagnation, is, of course, more socialist policies. That in turn will lead to falling wages, to replace the stagnation.
The economy is growing via growth of debt. If the trend of interest rates declining or being held down ends, then that is all that it will take to take down some of these historically-overpriced risk markets.
Methinks your kind are ringing the bell to mark the top.
link to telegraph.co.uk I have a slightly different spin on his rationale, I defer to his read but I consider that left to market forces the real interest rate would be much lower, and that rising LIBOR rates represents a coordinated effort to normalize against a deflationary tsunami of credit creation.
I want to mail it around to everyone I know. The value is in the time line, everyone has a different time line. How can an investment be a loser in the short term and a winner long term? It’s all predicated on a future which resembles the past. If you have used binomial charts you understand that the curve flattens (volatility) with the size of the sample. Given. Message to Baby Boomers, time is running out, they should be running away from this market though most of them have assets locked into pension funds. To sum that up if you are a boomer with assets outside your pension fund you should double sell, or short the market to hedge the losses your pension provider is going to take. Interesting times and decisions predicated on where you (personally) are in the cycle, and are you cognizant?
How can the so-called investment experts ignore the most important factors, unless they are talking their book and/or biases? Global investment dwarfs trade, stock buy backs, and anything the Fed will do. Yet, most ignore it, which is why the so-called experts have been wrong for at least seven years. Another important factor that I don’t see discussed is that dollar-based debts outside the US are much larger, foreign banks are in worse shape, and the trust in foreign govts is less (based on the anti-establishment and sucession movements). We also have the historic fact that economies always collapse from the periphery to the core.
The big money understands these facts and that sovereign defaults will start abroad, and the lack of confidence in govt will dry up demand for govt bonds, sending rates much higher, which exacerbates the insolvency death sprial. In this environment, where else does the big money go? When the govt bond bubble pops, what other market is big enough to absorb the flows?
Canada is beautiful, but it is a socialist basket case that is running off capital and people with increasing taxes and gloBull warming propaganda, which is why bail-in’s are the law of the land. Who wants to live in a country where banksters are officially prioritized over the deposits of citizens? With the coming mini ice age, higher property taxes and higher interest rates, I would sell RE while you still can.
BTW, these problems plague many US cities and states, which are prioritizing govt pensions over the general welfare of the state. This totalitarian trend will continue because govt’s never proactively reform, which is why our Founders made the right to bear arms the 2nd most important Amendment – which is also why govt’s always try to disarm their citizens. PAL, POL, FAC and other gun licencing does NOT keep guns out of the hands of criminals and crazies, but it does help with confiscation, which will turn law abiding citizens into criminals for simply wanting to protect themselves from criminals that never have a problem getting a weapon.
One would think that investment performance would carry some weight when it comes to credibility. Unfortunately, the broken clock analogy is not successful in investing. Doubling down on broken investment “logic” does not guarantee one will be right even once, much less twice.
Looks very similar to a Minsky Cycle. Are we at the Ponzi phase about to have a Minsky Moment? Most likely to happen when liquidity starts to dry up. Current rise in LIBOR rates could be the canary in the coal mine.
El_Tedo, I agree that it will take some substantial event, outside the market, to turn it. His prediction could happen, but it would take some external event to trigger it. But, in this world, with a growing global economy, it’s not like someone would be stupid enough to initiate a global trade war, or something, is it?
Realist said: The Canadian real estate market is still going strong.
Only if you’re wealthy Or a speculator. By destroyed I mean unattainable by the majority especially the young. They are all but priced out – where do the people who do minimum wage jobs live? The young rent rooms instead of apartments or homes. Many countries limit foreign investment and ownership of real estate for that reason but Canada didn’t and ruined it for a generation. Imaginary wealth and increased inequality is rampant in Canada. It won’t last because it can’t and the NDP being elected is like Trump being elected – it is a sign of discontent.
Hussman is a self-deluded bore. Permanent Pessimism is an addictive mental meme. He has embarrassed himself for 9 straight years and has lost a fortune for his investors. At this point, since he appears incapable of questioning as of his assumptions, he has no incentive to do anything but continue to double down on his hysteria. Of course the market will have a major correction again and even a crash, but can’t be wrong for a decade and then be vindicated. There has to be SOME timing tied to your prophesies. Some day the sun collapse and Earth will get sucked into its dark mass, but is that any reason to go short everything in the 21st century?
Well, Hussman is great and everything but at 4 or 5 years ago, he was saying that some Sornette oscilator pattern or something was saying the market crash was imminent. Clearly, it was not just the valuation extreme that he was talking about – he was talking about timing the crash. That never happened.
Perhaps Hussman would have been right if the markets were allowed to be free and allowed to fall instead of being propped up. But he can’t predict when the central bank interventions will begin to fail. And even if he did, there can be no assurance ,given his track record, that he would be right about that either.
The question is the political fall out from a second financial crash. They got away with it once, but not twice. Maybe that is why the super rich bought remote islands including New Zealand to build their safe houses to ride out the storm
Truthseeker: SweetKenny you need to get a sense of humor
If by sense of humor you mean patience with people who are overly grandiose, you are correct. It seems it is all too common these days – the road rage of the internet – it gets boring in its commonality.
Interesting, Mish, that the opening graphic reminded me of something similar in George Soros’ The Alchemy of Finance – but your anecdotes are informative. And, I suspect, spot on.
From the Hussman essay you reference:
“The important point is this: Extreme valuations are born not of careful calculation, thoughtful estimation of long-term discounted cash flows, or evidence-based reasoning. They are born of investor psychology, self-reinforcing speculation, and verbal arguments that need not, and often do not, hold up under the weight of historical data. Once investor preferences shift from speculation toward risk-aversion, extreme valuations should not be ignored, and can suddenly matter to their full extent. It appears that the financial markets may have reached that point.”
Thank you for referring us to the Hussman essay. His discussion of time horizons is both relevant and a breath of fresh air from the over-generalized “over the long run” type of rhetoric. In my situation (and age), long time horizons (say, 20+ years) are irrelevant: I’m looking at his 5 and 10 year lines.
Mish, you are becoming a daily required read.
Realist said: I think I’ve been listening about the coming crash in Canadian real estate for 20 years.
I agree that it has lasted far longer than I expected but I could say the same about the stock market. Private household debt rises every quarter but wages stay stagnant. We have no inflation but housing prices double. Chinese money destroyed the Canadian housing market and like any debt based system it only stays inflated as air (foreign money) continues to inflate it. BC just got an NDP government and a NDP budget. They threw the kitchen sink at foreign speculators including a 20% penalty and a yearly fee. Let’s wait and see.
With the greatest respect that’s a rather tired old adage that is actually false — particularly this time round. In short, the liquidity tsunami has caused a chase for yield which has, over time, caused pretty much all asset classes to become positively correlated, which means diversification does not provide any shelter. When liquidity is scarce it flows to the the most deserving risks. When there’s a glut, all risks (good and bad) benefit from inflows: the rising tide lifts all boats — even the leaky ones. If there’s a stock market crash anytime soon, bonds should benefit but there are no guarantees as yields are already historically low and there is huge supply coming down the pike (from both the Treasury and the Fed) in the coming years. The next crisis is likely to be different for all sorts of reasons.
Realist said: Stay as diversified as possible; stocks, bonds, real estate, etc.
At the risk of beating a dead horse,
link to cnbc.com
BlackRock also referenced commentary about the risk of index investing“to distort investment flows, create stock price bubbles, or conversely, exacerbate a decline in market prices.”
https://www.macroaxis.com/invest/ratio/BLK–Probability-Of-Bankruptcy
Oh and Mish would you consider doing an article on this, it’s too much for words:
link to reuters.com
link to reuters.com
Wasn’t it BlackRock who were the 50-trillion-sidecash lunatics?
link to s3-us-west-2.amazonaws.com
link to ft.com
This is conjecture on my part, but I don’t think the average institutional investor is in the stock market in a big way relatively speaking. After meditating on your post about fully invested bears, and also Dalio’s convictions about side cash versus cash in the market, I came to the conclusion that this last bull run has to have been driven by a relatively concentrated class of mostly of hedge fund managers buying on margin.
Years plural eh? I had in mind this would be a lot quicker than 2000- 2007- because of all the greater amount of leverage and the greater apathy of the average investor.
In Eliot wave terms I think we may be in something like move one down. A big 2 up sucker (not yet started) then a massive 3 of 3 down. wave 4 up and another huge wave 5 down. Except all of this will play out over years.
How is the market to crash if 675 billion of stock buybacks is announced?
I hardly ever delete remarks and I do not even recall deleting any of yours