Overvaluation, Deteriorating Market Action, and Coordinated Exit

John P. Hussman, Ph.D.

Notably, the broad market has essentially flat-lined since mid-2014, with the NYSE Composite still below its July 2014 level. Market behavior has also increasingly featured sequences of small, marginal advances punctuated by abrupt “air pocket” losses. This behavior reflects what I’ve often called “unpleasant skew.” See Impermanence and Full-Cycle Thinking for a chart of what the underlying return/risk distribution looks like.

 Every disciplined strategy has challenging periods over the course of a market cycle. They just come at different times. We’re seeing numerous hedge funds close, across a wide range of investment disciplines, as advisors and pension funds move away from strategies that involve discretion and selective investment, in preference for strategies that are always fully-exposed to market risk. 

I see this as pure, unadulterated, late-cycle, market-top behavior. 

Whether you’re a passive buy-and-hold investor or a tactical one, the dumbest thing a smart investor can do with a disciplined, historically-informed, full-cycle strategy is to abandon it after the portion of the cycle where it didn’t do well, and chase a different strategy that did well in hindsight. 

“Risk-on, all-the-time” has done well in recent years precisely because nearly every asset class has been driven to obscene valuations. 

By making a shift into passive strategies after-the-fact, investors are locking in the worst prospects for 10-12 year portfolio returns in history, along with the likelihood of awful interim losses.

 With regard to risk, investors should recognize: 

1) the potential risk of equity market losses on the order of 40-55%, which would still represent only a run-of-the-mill cycle completion from current valuations; 

2) the tendency for seemingly “safer” assets (e.g. dividend-paying stocks, utilities, international stocks in countries with generally lower valuations) to be highly correlated with the S&P 500 when U.S. stocks collapse; 

and 3) the potential for meaningful bond market losses on Treasuries, corporate bonds, and junk debt in response to yield spikes, given compressed yields, narrow risk-premiums on bonds, and a resulting elevation of durations.

DYI