John P. Hussman, Ph.D.
With regard to the stock market, I suspect that the first event in the completion of the current market cycle may be a vertical loss that would put the S&P 500 in the mid-1500’s in short order.
That area is a widely-recognized “role-reversal” support level matching the 2000 and 2007 market peaks, and would at least bring our estimates of prospective 10-year S&P 500 nominal total returns to about 5%, which seems a reasonable place for value-conscious investors to halt the initial leg down.DYI Comments: Stocks dropping to that level DYI's weighted formula will be buying some stocks. However at a reduced amount as stocks expressed by dividend yield will be less than its average. Improved valuations along with an improved forward return but not enough for a large commitment.
I’ve often noted the historical signature of market crashes: a sustained period of overvalued, overbought, overbullish conditions that is then coupled with a clear deterioration in market internals and hostile yield trends, particularly in the form of widening credit spreads. See my comments from the 2000 and2007 market peaks about the identical syndrome at those points. Historically, what we know as “crashes” have followed only after a compressed, initial market loss on the order of about 14%, a recovery that retraces 1/3 to 2/3 of the initial decline; and finally a break below that initial low. That threshold is currently best delineated by the 1800-1820 level on the S&P 500.
In the fixed income market, we wouldn’t touch low-grade credit at present.DYI Comments: I've been saying the same thing for months junk bonds are going to be decimated with a spread measured from Treasury bonds of 12% to 15% or more!
Once credit spreads widen sharply, the default cycle tends to kick in several quarters later. The present situation is much like what we observed in early 2008, when we argued that it was impossible for financial companies to simply “come clean” about bad debts, because then as now, the bulk of the defaults were still to come (see How Canst Thou Know Thy Counterparty When Thou Knowest Not Thine Self?).
As economic conditions have weakened, Treasury debt has been a safe-haven. Last week, the 10-year Treasury yield dropped to about 1.8%. My view is that a U.S. recession remains likely (see From Risk to Guarded Expectation of Recession and An Imminent Likelihood of Recession).DYI Comments: No doubt this economy is long in the tooth and is now "over due" for a downturn. Do what degree of severity is anyone's guess but no doubt there will be some level of layoffs and corporate bankruptcies on the horizon.
Coupled with widening credit spreads, that supports the expectation for even lower yields.DYI Comments: Yields will most likely go lower however for DYI bond yields are so low our weighted formula has "kick us out" of the market and rightfully so. At these sub atomic low rates as far as this blogger is concerned, rates are at a secular low, not the time for purchases of long term bonds for the long term investor.
But as yields become compressed, Treasuries bonds often become vulnerable to short-term yield spikes that can easily wipe out a year or two of prospective income in a few days. For that reason, our view on bonds remains constructive but not aggressive, and our inclination would be to reduce duration exposure as yields fall and extend it in the event of those spikes.
That brings us to precious metals. As I noted in the 1990’s, the strongest performance from gold stocks is generally associated with periods when 1) the year-over-year CPI inflation rate is higher than 6 months earlier; 2) Treasury yields are lower than 6 months earlier; 3) the ratio of spot gold to the XAU is greater than 4.0, and; 4) the ISM Purchasing Managers Index is below 50. All of those conditions have been present for the past couple of months, and gold stocks have staged a slightly delayed spike higher.DYI Comments: Gold shares have been decimated a bargain far greater than physical gold and/or other precious metals as well. Now is the time to dollar cost average into your favorite precious metals mining mutual fund.
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