Since early February, stock market investment risk has remained in the highest one percentile of all historical observations. The latest speculative advance during July increased risk to another historic extreme, joining a select group of four time periods that includes the long-term tops in 1929, 2000 and 2007.
According to the valuation components of the data used to calculate investment risk, the S&P 500 index is priced to produce an annual return of 2.8 percent during the coming decade. Therefore, when you take into account the current yield on the index, these highly reliable data suggest that stocks are poised to gain nothing during the next ten years. Granted, the market will likely go nowhere in an interesting fashion, but buy-and-hold investors who are entering the stock market at this level will almost certainly experience extremely poor performance during the next decade. Fueled by a historic amount of stimulus from the Federal Reserve, the cyclical bull market in stocks that began in 2009 continues to exhibit the characteristics of a classic bubble as defined by a log periodic advance.
As with all bubbles, it is impossible to predict when the top will form with a meaningful degree of statistical confidence. However, as with all bubbles, it is a virtual certainty that the forthcoming cyclical downtrend will be extremely violent and severe. In his latest weekly commentary, fund manager John Hussman explored the psychology that underpins this type of highly speculative market and we have reprinted an excerpt from his discussion below.
Two weeks ago, the blue-chip S&P 500 index advanced to a Shiller P/E of 24.6 (S&P 500 divided by the 10-year average of inflation-adjusted earnings). Notably, even using 10-year averaging, the implied profit margin embedded into Shiller earnings is about 18% above the historical norm. On normal profit margins, the Shiller P/E would now be at an even more extreme 29. Jim Chanos notes that more stocks are trading above three times book value today than at the 2000 market peak, which is largely because of a speculative runup in secondary issues. Indeed, small cap stocks and over-the-counter Nasdaq stocks have outpaced even the S&P 500 in recent months. Last week, Barronâ€™s magazine bubbled â€śthis is a golden era for initial public offerings,â€ť describing the IPO market as â€śwhite hot,â€ť featuring a flood of new offerings â€“ mainly small cap growth ventures.
All of this enthusiasm seems rather encouraging, unless one is familiar with market history, in which case one has to wince at the almost creepy re-emergence of these speculative hallmarks, in sequence. A couple of weeks ago, I quoted the words of former NYSE Chairman Bernard Lasker just before the 1969-1970 market plunge, but I slightly abridged the quote. Hereâ€™s a longer version:
â€śI can feel it comingâ€¦. a whole new round of disastrous speculation, with all the familiar stages in order â€“ a blue-chip boom, then a fad for secondary issues, then an OTC play, then another garbage market in new issues and finally the inevitable crash. I donâ€™t know when it will come but I can feel it coming and, damn it, I donâ€™t know what to do about it.â€ť
Decades ago, in his narrative A Short History of Financial Euphoria economic historian J.K. Galbraith lamented the â€śextreme brevity of the financial memory.â€ť He wrote, â€śIn consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by an always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.â€ť
â€śThere is protection only in a clear perception of the characteristics common to these flights into what must conservatively be described as mass insanity. Only then is the investor warned and saved. In the short run, it will be said to be an attack, motivated by either deficient understanding or uncontrolled envy, of the wonderful process of enrichment.â€ť
Consider Galbraithâ€™s analysis in the context of the tech bubble, the housing bubble, and the present QE-induced bubble:
â€śSpeculation building on itself provides its own momentum. This process, once it is recognized, is clearly evident, and especially so after the fact. So also, if more subjectively, are the basic attitudes of the participants. These take two forms. There are those who are persuaded that some new price-enhancing circumstance is in control, and they expect the market to stay up and go up, perhaps indefinitely. It is adjusting to a new situation, a new world of greatly, even infinitely increasing returns and resulting values. Then there are those, superficially more astute and generally fewer in number, who perceive or believe themselves to perceive the speculative mood of the moment. They are in to ride the upward wave; their particular genius, they are convinced, will allow them to get out before the speculation runs its course. They will get the maximum reward from the increase as it continues; they will be out before the eventual fall.
â€śFor built into this situation is the eventual and inevitable fall. Built in also is the circumstance that it cannot come gently or gradually. When it comes, it bears the grim face of disaster. That is because both of the groups of participants in the speculative situation are programmed for sudden efforts at escape. Something, it matters little what â€“ although it will always be much debated â€“ triggers the ultimate reversal.â€ť
In my view, deep losses await investors who are so willing to abandon the lessons of history, in the belief that the Fed has discovered some new economic principle and permanent safety net in quantitative easing. There is no question that our grounding in market history, my insistence on stress-testing our methods against Depression-era outcomes, our reliance on historically reliable valuation methods, all of these have been handicaps to one degree or another during the advancing portion of this unfinished half-cycle. Thatâ€™s given us a few bruises, but theyâ€™re smaller than the markets experience over a typical cycle, and nothing is broken.
Though I would have liked to choose a different time and different circumstances to learn certain things that weâ€™ve learned, the past few years have not encouraged us to abandon the evidence from a century of market history. To the contrary, weâ€™re encouraged to run to it â€“ not only for its promise but for its shelter. When I examine our present methods over market cycles across history, and even over the course of the most recent cycle, Iâ€™m convinced that theyâ€™re capable of navigating what is likely to be a volatile future. I expect that to be true regardless of whether the coming years will bring bubbles, crashes, growth, or recession; whether QE remains a fixture of monetary policy, or whether it turns out to be as specious as the Emperorâ€™s New Clothes. It is only an unending advance in prices, with no material retreat, that I think would be challenging. Of course, thatâ€™s exactly what investors have experienced since late-2011, and as Galbraith noted, thatâ€™s exactly the scenario that speculators believe will continue indefinitely, until the moment they discover otherwise.