Stock Market Investment Risk Remains Near Historic High

| July 4, 2013

Our Secular Trend Score (STS) and Cyclical Trend Score (CTS) are calculated using a large basket of fundamental, technical, internal and sentiment data. The historical data used by our models extend back to the market crash in 1929 and have enabled our STS to correctly identify every secular inflection point and our CTS to correctly identify more than 90 percent of all cyclical inflection points during the last 84 years. Additionally, when analyzed collectively, these data identify extremes in the risk/reward profile of the stock market from an investment perspective. Since early February, stock market investment risk has remained in the highest one percentile of all historical observations, joining a select group of five time periods that includes the long-term tops in 1929, 1973, 2000 and 2007.

This particular measurement of investment risk is not a top call or an indication that a severe market decline is imminent. Overbought rallies such as this one can remain overbought for a long time as speculative momentum carries prices to higher and higher extremes. What the current investment risk/reward profile tells us is that a severe market decline will almost certainly occur after the current cyclical bull market terminates. According to these historical data, the S&P 500 index is currently priced to produce an annual return of 2.9 percent during the coming decade. The following graph from the Hussman Funds website displays a variety of projected returns based on the historically reliable valuation model, and they all agree that the investment outlook for the stock market is very poor at current levels.

Through its unprecedented monetary stimulus programs, the Federal Reserve has created massive market distortions, effectively stealing returns from the future and bringing them into the present. In its recent annual report, the Bank for International Settlements reflected on the short-term thinking that has resulted in these market distortions.

What central bank accommodation has done during the recovery is to borrow time – time for balance sheet repair, time for fiscal consolidation, and time for reforms to restore productivity growth. But the time has not been well used, as continued low interest rates and unconventional policies have made it easy for the private sector to postpone deleveraging, easy for the government to finance deficits, and easy for the authorities to delay needed reforms in the real economy and in the financial system. After all, cheap money makes it easier to borrow than to save, easier to spend than to tax, easier to remain the same than to change.

We have avoided taking the difficult steps that will ultimately be required to heal our economy and lay the foundation for the next structural growth cycle. Instead, we continue to buy time via short-term measures. Although the recent quantitative easing programs have not meaningfully addressed the structural problems that are weighing on our economy, they have successfully inflated the stock market, creating yet another bubble. Unless this time is different, and the fundamental nature of the business cycle has somehow been changed, the current stock market bubble will end as badly as all previous bubbles. It remains to be seen what form the catalyst for the bubble implosion will take, and it is usually something that conventional thought had not been expecting. However, it is not a matter of if the bubble will burst, but when.


Category: Commentary, Market Update

Comments are closed.