August 22, 2016

Looking Ahead to a Bullish Outlook 

(and What Will Define It)

John P. Hussman, Ph.D.

Current market conditions place our evaluation of the expected market return/risk profile in the most negative classification we identify. Following the British vote to exit the European Union, global economic concerns, coupled with weakness in the Japanese economy, drove interest rates in Britain, Europe and Japan to fresh lows, prompting a burst of yield-seeking speculation that has driven the S&P 500 Index a few percent above its May 2015 peak. At its core, the attempt of central banks to remove any lower bound on yields is an attempt to remove any upper bound on speculation. We expect that materially negative yields will be extremely difficult to sustain, not only for political and economic reasons, but also because the cheap alternative of placing physical currency in a safe creates an arbitrage constraint. 

The latest yield-seeking euphoria has flattered speculators into believing that imprudence is merely sound investing. As valuations rise, prospective future returns fall, and our 12-year projection for S&P 500 nominal total returns has now dropped to just 1.4% annually. But to reward risk-taking artificially, and for too long, is to amplify the amount of systemic risk that is created. Along with the steepest equity valuations in U.S. history outside of 1929 and 2000 (on measures that are actually reliably correlated with subsequent market returns), private and public debt burdens have reached the most extreme levels in history. 

My impression is that the market is heaving its last gasp in the extended two-year top formation of the third financial bubble since 2000.

Paul Singer fund: Market 'breakdown' to be 'sudden, intense, and large'

Too much power has been ceded to central banks, the letter adds, the value of money has been debased, inflation is probably inevitable, and when it happens, it could be swift and impossible to tamp down. 

In one wry aside, the letter suggests a safety warning be attached to the $12 trillion government bond market now trading at negative yields: "Hold such instruments at your own risk; danger of serious injury or death to your capital!" 

Among other things, the letter adds, the hedge fund is seeing opportunity in the distressed-energy sector despite the rebound of oil and gas prices from their lows. The fund also has been building up its gold position "in a conditional format," to ebb losses "should prices fall back from their recent strength."

The Marginal Buyer Holds The Pin That Pops Every Asset Bubble

Bubble Territory

The takeaway from the above is that prices are set by two things: the upper limit that the marginal buyer is willing to pay, and how intensely the competition from other buyers pushes him towards that limit. 

This is just as true for stocks and housing as it is for fine art. 

And we're now seeing some concerning signs that the marginal buyers, as well as their competitors, are beginning to go on strike across those asset classes. 

Let's look at the stock market. For the past 5 years, stock prices have been powering higher. Good, right? Well, not so good when you look at the volume underlying these prices. Volume has been in decline over this period, and the rate of decline has accelerated since the beginning of this year. This means fewer buyers -- less competition -- pushing the marginal buyer to spend more. Which likely explains why the S&P 500 index is roughly unchanged from where it was 2 years ago.

DYI