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Hussman, fundamentals of market deterioration
The people who do NOT understand the economy work in academia or television. The people who do understand the economy guide investment firms and write private investment letters. BUT, there are some people who understand the economy AND write for the public.
John Hussman phd is one of the very best technical writers who writes for the public. Some years ago, he saw that the stock market was highly over-valued. He guided his clients to take bearish actions. He and his clients lost a LOT of money because the markets continued to go higher and higher. He has now figured out where he went wrong. The markets went higher because of foreign capital inflows. Something that Armstrong had stressed but, most people had ignored. Here is an excellent article from Hussman.
"In the recent advancing half-cycle, the speculation intentionally provoked by zero-interest rate policy forced us to elevate the priority of market internals to a far greater degree than was required during the tech and mortgage bubbles. It was necessary to prioritize the behavior of market internals even over extreme “overvalued, overbought, overbullish” features of market action. Those syndromes were effective in other cycles across history, but in the advancing half-cycle since 2009, our bearish response to those syndromes proved to be our Achilles Heel."
He has since learned that an overbought market is NOT enough to precipitate a crash. In the 2 previous crashes, it WAS an adequate predictor.
His track record.
By March 2000, on the basis of historically reliable valuation measures, I projected that a retreat to normal valuations would require an -83% plunge in tech stocks. In the 19 months that followed, that estimate turned out to be precise for the tech-heavy Nasdaq 100 Index.
So, he was correct in 2000 based just on valuations.
"Delusions are best understood not as deficiencies in logic, but rather as explanations that have been logically reached on the basis of distorted inputs. Similarly, Garety & Freeman found that delusions appear to reflect not a defect in reasoning itself, but a defect “which is best described as a data-gathering bias, The reason that delusions are so hard to fight with logic is that delusions themselves are established through the exercise of logic. Responsibility for delusions is more likely to be found in distorted perception or inadequate information. The problem isn’t disturbed reasoning, but distorted or inadequate inputs.
" where speculative behavior increasingly produces self-reinforcing feedback. Specifically, the speculative behavior of the crowd results in rising prices that both impress and reward speculators, and in turn encourage even greater speculation. The more impressed the crowd becomes with the result of its own behavior, the more that behavior persists, and the more unstable the system becomes,
The problem was that investors stopped thinking about stocks as a claim on a very, very long-term stream of discounted cash flows. Valuations didn’t matter. It was enough that the economy was expanding. It was enough that earnings were rising. Put simply, the trend of earnings and the economy, not the actual level of valuation, became the justification for buying stocks. Graham & Dodd described this process:
"The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd.
Missing from Yellen’s benign assessment was the fact that the speculative distortion and debt buildup enabled by the bubble itself would be the primary driver of the worst economic collapse since the Great Depression. The Fed appears to exclude such risks from its thinking,
Despite risks that I fully expect to devolve into a roughly -65% loss in the S&P 500 over the completion of the current market cycle
"it’s absolutely critical to distinguish the long-term effects of valuation from the shorter-term effects speculative pressure. Historically-reliable valuation measures are remarkably useful in projecting long-term and full-cycle market outcomes, but the behavior of the market over shorter segments of the market cycle is driven by the psychological inclination of investors toward speculation or risk-aversion. "
There you have it. He previously looked at valuation in the long run with taking into account market sentiment.
"zero-interest rate policy forced us to elevate the priority of market internals to a far greater degree than was required during the tech and mortgage bubbles."
" The process of adaptation was very incremental, and therefore painful in the face of persistent speculation. We’ve adapted our investment discipline so that without exception, a negative market outlook can be established only in periods when our measures of market internals have also deteriorated. A neutral outlook is fine when conditions are sufficiently unfavorable, but establishing a negative outlook requires deterioration and dispersion in market internals."
A crash must be preceded by a fall in confidence, NOT just over-valuation.
"Faced with extreme valuations, the first impulse of investors should not be to try to justify those valuation extremes, but to recognize the impact of their own speculative behavior in producing and sustaining those extremes. It then becomes essential to monitor market conditions for the hostile combination of extreme valuations and deteriorating market internals. At present, we observe that combination, but would still characterize the deterioration in market internals as “early,” in the sense that it’s permissive of abrupt market losses, but not severe enough to infer a clear shift from speculation to risk-aversion among investors."
OK, so we are still "early" in the credit half cycle. BUT, the speed of deterioration is likely to rapidly pick up.
"Speculation is dangerous because it encourages the belief that just because prices are elevated, they must somehow actually belong there. It encourages the belief that the paper itself is wealth, rather than the stream of future cash flows that investors can expect their securities to deliver over time. "
A big part of the over-valuation is that investors are looking for protection, NOT necessarily future cash flow.
I previously wrote about the near unlimited issuance of things that investors call "assets"
"It takes only a bit more thought to recognize that securities, in themselves, are not net wealth. Rather, every security is an asset to the holder, and an equivalent liability to the issuer."
"The IOU is a new security, but it doesn’t represent new economic wealth."
"Neither the creation of securities, nor changes in their price, create net wealth or purchasing power for the economy. Yes, an individual holder of a security can obtain a transfer of wealth from someone else in the economy, provided that the holder actually sells the security to some new buyer while the price remains elevated. But in aggregate, the economy cannot consume off of its paper “wealth,” because in aggregate, those paper securities cannot be sold without someone else to buy them, and those paper securities must be held by someone until they are retired. "
"What actually matters, in aggregate, is the stream of cash flows. Specifically, the activity that produces actual economic wealth is value-added production, which results in goods and services that did not exist previously with the same value. Value-added production is what actually “injects” purchasing power into the economy, as well as the objects available to be purchased."
"If one carefully accounts for what is spent, what is saved, and what form those savings take (securities that transfer the savings to others, or tangible real investment of output that is not consumed), one obtains a set of “stock-flow consistent” accounting identities that must be true at each point in time:
1) Total real saving in the economy must equal total real investment in the economy;
2) For every investor who calls some security an “asset” there’s an issuer that calls that same security a “liability”;
3) The net acquisition of all securities in the economy is always precisely zero, even though the gross issuance of securities can be many times the amount of underlying saving; "
"4) When one nets out all the assets and liabilities in the economy, the only thing that is left – the true basis of a society’s net worth – is the stock of real investment that it has accumulated as a result of prior saving, and its unused endowment of resources. Everything else cancels out because every security represents an asset of the holder and a liability of the issuer. Securities are not net wealth."
This isn't 100% true because the Central Bank can pass out free money that is not a liability. Much of the TARP money was not repaid.
"the wealth of a nation consists of its stock of real private investment (e.g. housing, capital goods, factories), real public investment (e.g. infrastructure), intangible intellectual capital (e.g. education, knowledge, inventions, organizations, and systems), and its endowment of basic resources such as land, energy, and water. In an open economy, one would include the net claims on foreigners (negative, in the U.S. case). A nation that expands and defends its stock of real, productive investment is a nation that has the capacity to generate a higher long-term stream of value-added production, and to sustain a higher long-term standard of living."
Funny, he doesn't mention banks.
"Understand that securities are not net economic wealth. They are a claim of one party in the economy – by virtue of past saving – on the future output produced by others. When paper “wealth” becomes extremely elevated or depressed relative to the value-added produced by an economy, it’s the paper “wealth” that adjusts to eliminate the gap."
Currently, there is VERY little wealth from past savings. With free money from the CB, the speculators didn't have to trouble themselves with paying decent interest on savings so that they could attract saved capital.
"Several years ago, I introduced what remains the single most reliable measure of valuation we’ve ever developed or tested,"
"Among the valuation measures we find best correlated with actual S&P 500 total returns in market cycles across history, the S&P 500 is currently more than 2.8 times its historical norms. "
"So even given the level of interest rates, we expect a market loss of about -65% to complete the current speculative market cycle."
The people who do NOT understand the economy work in academia or television. The people who do understand the economy guide investment firms and write private investment letters. BUT, there are some people who understand the economy AND write for the public.
John Hussman phd is one of the very best technical writers who writes for the public. Some years ago, he saw that the stock market was highly over-valued. He guided his clients to take bearish actions. He and his clients lost a LOT of money because the markets continued to go higher and higher. He has now figured out where he went wrong. The markets went higher because of foreign capital inflows. Something that Armstrong had stressed but, most people had ignored. Here is an excellent article from Hussman.
"In the recent advancing half-cycle, the speculation intentionally provoked by zero-interest rate policy forced us to elevate the priority of market internals to a far greater degree than was required during the tech and mortgage bubbles. It was necessary to prioritize the behavior of market internals even over extreme “overvalued, overbought, overbullish” features of market action. Those syndromes were effective in other cycles across history, but in the advancing half-cycle since 2009, our bearish response to those syndromes proved to be our Achilles Heel."
He has since learned that an overbought market is NOT enough to precipitate a crash. In the 2 previous crashes, it WAS an adequate predictor.
His track record.
By March 2000, on the basis of historically reliable valuation measures, I projected that a retreat to normal valuations would require an -83% plunge in tech stocks. In the 19 months that followed, that estimate turned out to be precise for the tech-heavy Nasdaq 100 Index.
So, he was correct in 2000 based just on valuations.
"Delusions are best understood not as deficiencies in logic, but rather as explanations that have been logically reached on the basis of distorted inputs. Similarly, Garety & Freeman found that delusions appear to reflect not a defect in reasoning itself, but a defect “which is best described as a data-gathering bias, The reason that delusions are so hard to fight with logic is that delusions themselves are established through the exercise of logic. Responsibility for delusions is more likely to be found in distorted perception or inadequate information. The problem isn’t disturbed reasoning, but distorted or inadequate inputs.
" where speculative behavior increasingly produces self-reinforcing feedback. Specifically, the speculative behavior of the crowd results in rising prices that both impress and reward speculators, and in turn encourage even greater speculation. The more impressed the crowd becomes with the result of its own behavior, the more that behavior persists, and the more unstable the system becomes,
The problem was that investors stopped thinking about stocks as a claim on a very, very long-term stream of discounted cash flows. Valuations didn’t matter. It was enough that the economy was expanding. It was enough that earnings were rising. Put simply, the trend of earnings and the economy, not the actual level of valuation, became the justification for buying stocks. Graham & Dodd described this process:
"The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd.
Missing from Yellen’s benign assessment was the fact that the speculative distortion and debt buildup enabled by the bubble itself would be the primary driver of the worst economic collapse since the Great Depression. The Fed appears to exclude such risks from its thinking,
Despite risks that I fully expect to devolve into a roughly -65% loss in the S&P 500 over the completion of the current market cycle
"it’s absolutely critical to distinguish the long-term effects of valuation from the shorter-term effects speculative pressure. Historically-reliable valuation measures are remarkably useful in projecting long-term and full-cycle market outcomes, but the behavior of the market over shorter segments of the market cycle is driven by the psychological inclination of investors toward speculation or risk-aversion. "
There you have it. He previously looked at valuation in the long run with taking into account market sentiment.
"zero-interest rate policy forced us to elevate the priority of market internals to a far greater degree than was required during the tech and mortgage bubbles."
" The process of adaptation was very incremental, and therefore painful in the face of persistent speculation. We’ve adapted our investment discipline so that without exception, a negative market outlook can be established only in periods when our measures of market internals have also deteriorated. A neutral outlook is fine when conditions are sufficiently unfavorable, but establishing a negative outlook requires deterioration and dispersion in market internals."
A crash must be preceded by a fall in confidence, NOT just over-valuation.
"Faced with extreme valuations, the first impulse of investors should not be to try to justify those valuation extremes, but to recognize the impact of their own speculative behavior in producing and sustaining those extremes. It then becomes essential to monitor market conditions for the hostile combination of extreme valuations and deteriorating market internals. At present, we observe that combination, but would still characterize the deterioration in market internals as “early,” in the sense that it’s permissive of abrupt market losses, but not severe enough to infer a clear shift from speculation to risk-aversion among investors."
OK, so we are still "early" in the credit half cycle. BUT, the speed of deterioration is likely to rapidly pick up.
"Speculation is dangerous because it encourages the belief that just because prices are elevated, they must somehow actually belong there. It encourages the belief that the paper itself is wealth, rather than the stream of future cash flows that investors can expect their securities to deliver over time. "
A big part of the over-valuation is that investors are looking for protection, NOT necessarily future cash flow.
I previously wrote about the near unlimited issuance of things that investors call "assets"
"It takes only a bit more thought to recognize that securities, in themselves, are not net wealth. Rather, every security is an asset to the holder, and an equivalent liability to the issuer."
"The IOU is a new security, but it doesn’t represent new economic wealth."
"Neither the creation of securities, nor changes in their price, create net wealth or purchasing power for the economy. Yes, an individual holder of a security can obtain a transfer of wealth from someone else in the economy, provided that the holder actually sells the security to some new buyer while the price remains elevated. But in aggregate, the economy cannot consume off of its paper “wealth,” because in aggregate, those paper securities cannot be sold without someone else to buy them, and those paper securities must be held by someone until they are retired. "
"What actually matters, in aggregate, is the stream of cash flows. Specifically, the activity that produces actual economic wealth is value-added production, which results in goods and services that did not exist previously with the same value. Value-added production is what actually “injects” purchasing power into the economy, as well as the objects available to be purchased."
"If one carefully accounts for what is spent, what is saved, and what form those savings take (securities that transfer the savings to others, or tangible real investment of output that is not consumed), one obtains a set of “stock-flow consistent” accounting identities that must be true at each point in time:
1) Total real saving in the economy must equal total real investment in the economy;
2) For every investor who calls some security an “asset” there’s an issuer that calls that same security a “liability”;
3) The net acquisition of all securities in the economy is always precisely zero, even though the gross issuance of securities can be many times the amount of underlying saving; "
"4) When one nets out all the assets and liabilities in the economy, the only thing that is left – the true basis of a society’s net worth – is the stock of real investment that it has accumulated as a result of prior saving, and its unused endowment of resources. Everything else cancels out because every security represents an asset of the holder and a liability of the issuer. Securities are not net wealth."
This isn't 100% true because the Central Bank can pass out free money that is not a liability. Much of the TARP money was not repaid.
"the wealth of a nation consists of its stock of real private investment (e.g. housing, capital goods, factories), real public investment (e.g. infrastructure), intangible intellectual capital (e.g. education, knowledge, inventions, organizations, and systems), and its endowment of basic resources such as land, energy, and water. In an open economy, one would include the net claims on foreigners (negative, in the U.S. case). A nation that expands and defends its stock of real, productive investment is a nation that has the capacity to generate a higher long-term stream of value-added production, and to sustain a higher long-term standard of living."
Funny, he doesn't mention banks.
"Understand that securities are not net economic wealth. They are a claim of one party in the economy – by virtue of past saving – on the future output produced by others. When paper “wealth” becomes extremely elevated or depressed relative to the value-added produced by an economy, it’s the paper “wealth” that adjusts to eliminate the gap."
Currently, there is VERY little wealth from past savings. With free money from the CB, the speculators didn't have to trouble themselves with paying decent interest on savings so that they could attract saved capital.
"Several years ago, I introduced what remains the single most reliable measure of valuation we’ve ever developed or tested,"
"Among the valuation measures we find best correlated with actual S&P 500 total returns in market cycles across history, the S&P 500 is currently more than 2.8 times its historical norms. "
"So even given the level of interest rates, we expect a market loss of about -65% to complete the current speculative market cycle."
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