Speculative Half-Cycles Tend To Be Completed Badly

John P. Hussman, Ph.D.

Presently, a further 40-50% collapse in the S&P 500 over the completion of this market cycle would not represent a worst-case scenario, but rather a run-of-the-mill outcome from current valuations. That prospect is coupled with an expectation of a U.S. recession, and the likelihood that Fed easing will be wholly ineffective in preventing either. Give us different evidence, and the immediacy of our conclusions will change. 

I use the word “immediacy” because valuations speak to long-term returns, not returns over shorter portions of the market cycle. Over shorter horizons, the primary driver of market fluctuations is the willingness or aversion of investors to embrace risk. Since investors tend to be indiscriminate when they are in a risk-seeking mode, we find that the most reliable measure of that risk-seeking is the uniformity of market internals across a broad range of individual stocks, industries, sectors, and security types, including debt securities of varying creditworthiness. Give us an improvement in those internals, and despite what we view as extreme valuations where dismal long-term returns are baked in the cake, the immediacy of our downside concerns would be reduced.

DYI Comments:  For those of you who are buy and hold investors with a set investment allocation you may want to "stress test" how much downside pain you can endure.  60% stock / 40% bond allocation expect a portfolio drop from peak to trough of around 25% - 35% depending on the composition of your stocks(large cap vs small cap) or your bonds(gov't, high grade corp. or junk).  If a 35% is too much grief then dial down your exposure to the flip side with 40% stock / 60% bonds. This will place your drop to the 15% - 25% range again depending on the composition.

As a side note for savers who have to become investors because of their 401k's I advocate using 40% stocks / 60 bonds approach.  Many will fault me for being too conservative.  These folks are your basic savers looking for a relative smooth ride and for those who are the nervous types 35% stocks / 65% bonds.  That allocation has served Vanguard's Wellesley Income Fund symbol VWINX very well and has many investors who been with the fund for decades.  Something to be said for the not so fearful ride.

DYI