Memorize This, Earn A Dollar – John Hussman
Sometimes, they do ring a bell
Last week, Bill Hester showed me a few charts, saying, “Here’s something you’re very aware of, but I still found interesting.”
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The first chart shows points in history when the S&P 500 has registered a record high within the prior 8-week period, with advisory bearishness (Investors Intelligence) below 27%, and the Shiller P/E (S&P 500 divided by the 10-year average of inflation-adjusted earnings) greater than 18. While we certainly believe there are better valuation measures than the Shiller P/E (particularly MarketCap/GVA), we use it below because it is widely followed. With advisory bearishness down to 15.6% and the Shiller P/E recently pushing 27, the market is far beyond these thresholds in any event.
Notice something. In prior cycles before 2009, this set of conditions alone (the crudest possible combination of overvalued, overbought, overbullish conditions) was typically followed by moderate to severe market losses. Though it doesn’t look like much on a log scale, that retreat in 1998 approached a 20% market loss, and the series of corrections approaching the 2000 peak were in the range of 8-12% each. In a few cases, the losses were modest and the conditions were quickly cleared, but in 1972, 1987, 2000 and 2007, the follow-through was quite deep. Now look at the solid block of instances in recent years. As the Dixie Chicks would say, there’s your trouble. Measuring overbought conditions by something other than a record high, that red block would extend back even further.
In prior market cycles across history, taking a hard-defensive outlook in response to overvalued, overbought, overbullish conditions rarely kept you on the wrong side of the market for long; either the market declined, or the syndrome was cleared. But in the face of monetary policy that has intentionally encouraged yield-seeking speculation in recent years, what’s needed in the chart above? Go back to the Iron Laws. We need to impose a measure of market internals. You may recall similar charts that I published as late as May 2014, where measures of market internals are also missing. That’s the essential requirement that we imposed on our methods in mid-2014, and that ended the awkward transition from our pre-2009 methods to our present methods of classifying market return/risk profiles – avoid a hard-defensive outlook unless unfavorable conditions are confirmed by deterioration in market internals or credit spreads.
When investors are risk-seeking, they tend to be risk-seeking in everything, so the uniformity of market action conveys a great deal of information about their preferences. When market internals begin to break down, it’s a signal that investor preferences have shifted toward risk-aversion. In that environment, previously benign overvaluation can quickly become disastrous, and as we saw during 2000-2002 and 2007-2009, even persistent and aggressive monetary easing doesn’t reliably support the market.
The chart below imposes one additional condition, showing periods where fewer than 60% of S&P 500 stocks were above their respective 200-day moving averages. This is as clear and simple as the Iron Laws can get. The worst market outcomes in history have always emerged after an overvalued, overbought, overbullish advance has been joined by deterioration in market internals.
Let’s go one step further, and restrict these instances to weeks where the S&P 500 had just set a record weekly closing high. That restriction kicks out 1987. In that instance, the earliest warnings were from weakness in utilities and corporate bonds, but the percentage of stocks above their own 200-day averages didn’t fall below 60% until the market itself was already down nearly 10% from its high; less than two weeks before the crash. Many trend-followers were caught off-guard because the warning period was so brief. If one wasn’t following a broad range of market internals, one needed to respond almost immediately to the emerging weakness in order to avoid the collapse.
The remaining signals (record high on a weekly closing basis, fewer than 27% bears, Shiller P/E greater than 18, fewer than 60% of S&P 500 stocks above their 200-day average), are shown below. What’s interesting about these warnings is how closely they identified the precise market peak of each cycle. Internal divergences have to be fairly extensive for the S&P 500 to register a fresh overvalued, overbullish new high with more than 40% of its component stocks already falling – it’s evidently a rare indication of a last hurrah. The 1972 warning occurred on November 17, 1972, only 7 weeks and less than 4% from the final high before the market lost half its value. The 2000 warning occurred the week of March 24, 2000, marking the exact weekly high of that bull run. The 2007 instance spanned two consecutive weekly closing highs: October 5 and October 12. The final daily high of the S&P 500 was October 9 – right in between. The most recent warning was the week ended July 17, 2015.