John Hussman: 'Justified Consequences'

Market conditions continue to be characterized by the likelihood of extremely poor long-term and full-cycle outcomes, with expected -…- to ---year estimated Standard & Poor's 5…… nominal total returns in the …% to -% range, negative expected real returns on both horizons and the continued likelihood of a 4…% to 55% interim market loss over the completion of the current cycle; a decline that would represent only a typical run-of-the-mill cycle completion, based on valuation measures most tightly related with actual subsequent market returns across history.

The degree of second-guessing regarding historically reliable valuation measures is perplexing, given that there has been no deterioration whatsoever in the correlation between these measures and subsequent market returns on a -…- to ---year horizon (see the recent comment, " Permanently High Plateaus Have Poor Precedents ," and note that these measures have been just as reliable in recent cycles as they have been for the better part of a century).

Yes, from a cyclical perspective, the psychological inclination of investors toward risk seeking or risk aversion, as conveyed by the uniformity or divergence of market internals, is essential in distinguishing between overvalued markets that become more overvalued and overvalued markets that drop like a rock. This is where the Federal Reserve regularly exerts its recklessly misguided and needlessly distorting impact, amplifying risk seeking when investors are already inclined to speculate and become impotent once investors shift to risk aversion (see " When an Easy Fed Doesn't Help Stocks "), but this is a distinction that plays out over shorter segments of the market cycle.

To a large extent, the second guessing of historically reliable valuation measures revolves around the meaning of the word "justified." Specifically, many investors have been led to accept the premise that current extreme valuations are justified by today's suppressed level of interest rates.

There are two responses to this premise. First, the correlation between interest rates and equity valuations is far weaker than investors seem to believe, and even the modest inverse correlation in historical data (lower interest rates being associated with higher valuations) is fully attributable to the disinflationary period from -98…--997. Outside of this period, the historical correlation between interest rates and valuations has been zero. If one excludes the full inflation-disinflation period from -97…--997, the correlation between interest rates and valuations has actually been modestly positive; lower interest rates have been correlated with lower, not higher, valuations.

The back story here is that, when interest rates are super low, it's typically because nominal growth has been crummy. Whenever investors have responded to depressed interest rates by paying extreme valuations anyway, they've been sorry (see " Rarefied Air: Valuations and Subsequent Market Returns ," for more detail, including a mathematical decomposition). Extreme valuations, on historically reliable measures, are invariably associated with dismal subsequent returns on a -…- to ---year horizon. As much as one might protest the historical evidence, there's no use getting upset over a fact.

The following chart, which I presented last May near the peak

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DDAY 15-Year Financial Data

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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