Recognizing the Risks to Financial Stability
John P. Hussman, Ph.D.
John P. Hussman, Ph.D.
Unfortunately, on the most historically reliable measures, equity valuations are now more than 130% above the levels that would historically be associated with run-of-the-mill 10% equity returns (the premium is about 116% above historical norms if we use a broader though still reliable set of measures). These valuations might be reasonable on the assumption that short-term interest rates will be kept at zero for more than 30 years, but our impression is that what’s actually going on is that investors feel they have “nowhere else to go” and – as in 2000 and 2007 – are speculating without a clear recognition of the dismal long-term returns that are now priced into equities. In effect, investors have priced stocks not only on the expectation of many more years of zero interest rates, but also without any material risk premium at all. As a result, the most historically reliable valuation measures now suggest that the S&P 500 will experience a net loss over the coming decade, while including broader (if slightly less reliable) measures results in projected S&P 500 10-year annual nominal total returns of about 1.4% annually (see Ockham’s Razor and the Market Cycle for the arithmetic behind these estimates).
From an investment standpoint, market conditions remain characterized both by obscene valuations and still-negative market internals. It’s that combination that continues to suggest potentially vertical downside risks. When people think about crashes, they tend to think about an event – as if some massive, grotesque, red, scaly, fire-breathing, razor-toothed catalyst should be obvious beforehand. But we know from history that that’s not the way it works. Instead, the sequence goes like this: the conditions that create vulnerability to a crash emerge first (elevated valuations coupled with deterioration in market internals and/or widening in credit spreads), the crash emerges second, and catalysts are then identified – often just flashpoints that were consistent with speculative breakdown. Many investors think that “Lehman” caused the global financial crisis, but the mortgage crisis was already unfolding well before that. Lehman and Bear Stearns before it were only symptoms, not causes. The cause is always speculative distortion that was well-known for quite some time: elevated valuations, often accompanied by speculation and new issues of low-quality stocks representing some “new economy” theme, or yield-seeking speculation and heavy issuance of low quality debt. The main reason investors don’t believe that such speculation will end in a crash is simply that a crash hasn’t happened yet.
Analysts were shocked on when data released on Wednesday showed that the Gross Domestic Product (GDP) in the first quarter grew sharply less than they had expected -- 0.2%, rather than the predicted 1%, after rising 2.2% in the last quarter of last year.
As usual, the mainstream economists called it just a blip, nothing to be concerned about, but if they really believed that then they wouldn't have been shocked. The problem is that this has been going on for years, since the 2007 credit crunch. Every time the GDP goes up a bit, as it did in Q4, mainstream economists pull out their macroeconomic models from the 70s, 80s, and 90s, and announce that the economy is finally on an upsurge, and that the "Great Recession" is finally ending. So the shock is not that they got it wrong this time, but that they got it wrong time after time after time since 2007.
Long-time readers will recall that I used to repeatedly mock and make fun of mainstream economists. Each quarter I would post the consensus forecasts for growth in that quarter, and then the actual growth figures when they came out. It was a major farce.
I always like to point out that mainstream economists didn't foresee and still can't explain the tech bubble at the end of the 1990s, or why it occurred at that time and not during the PC explosion of the 1980s. They didn't foresee and can't explain the Nasdaq crash in 2000, didn't foresee and can't explain the real estate and credit bubbles of the mid-2000s, didn't foresee and can't explain the credit crunch that began in 2007, didn't foresee and can't explain the global financial crisis, and have gotten wrong almost every forecast since then.
The reason that the tech bubble occurred in the late 1990s is because that's exactly the time when the risk-averse survivors of the 1929 crash and Great Depression all disappeared (retired or died), leaving behind the younger generations with no personal knowledge of the dangers of debt. Generational theory can explain almost everything that's occurred in the last 15 years, but mainstream economists never think of this because they have a brain malfunction that keeps them from understanding even the simplest and most obvious generational explanation of anything. At any rate, if they want to get their forecasts right, then they have to dig out the macroeconomic models from the 1930s, and throw away the models from the 70s-90s, which are irrelevant today.
According to Friday's Wall Street Journal, the S&P 500 Price/Earnings index (stock valuations index) on Friday morning (May 1) was astronomically high, just below 21. This is far above the historical average of 14. Furthermore, it was 18 just a year ago, indicating that the stock market bubble is getting so large it's close to exploding. Generational Dynamics predicts that a panic will occur, and that the P/E ratio will fall to the 5-6 range or lower, which is where it was as recently as 1982, resulting in a Dow Jones Industrial Average of 3000 or lower.
So we have a continuation of their bizarre situation where the economy is getting weaker (or, at least, not getting stronger), which causes the Fed to pursue policies that pour billions of dollars into the banking system, which finds its way into the stock market bubble and into the pockets of the "top 1%." If you want to know why there are no jobs in Baltimore and elsewhere, this is where you should be looking.DYI
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