As last week’s QE3 announcement juiced equities, valuations began to look stretched according to some long-term metrics (such as the Shiller PE, which approached 24). The Bulls certainly proved to be in the majority as the market’s upward move was substantial, but as gold prices surged after the QE3 announcement as well, it was clear that some investors were growing increasingly wary of inflation and general market frothiness.
Enter John Hussman. Never one prone to irrational exuberance, Mr. Hussman’s proprietary model generated crash-warnings in the years 2000 and again in 2007. Then, as now, the model incorporates decades of market data, as well as leading economic indicators, technical indicators and a variety of valuation measures. Some have criticized Mr. Hussman for not being sufficiently bullish in early 2009, though it must be said that his primary objective in trying to outperform in a complete market cycle is the avoidance of large drawdowns, at which objective he is historically adept. And his weekly market comment published today is rather dire.
As of Friday, our estimates of prospective return/risk for the S&P 500 have dropped to the single lowest point we’ve observed in a century of data. There is no way to view this as something other than a warning, but it’s also a warning that I don’t want to overstate. This is an extreme data point, but there has been no abrupt change; no sudden event; no major catalyst. We are no more defensive today than we were a week ago, because conditions have been in the most negative 0.5% of the data for months. This is just the most negative return/risk estimate we’ve seen. It is what it is.
Alright, so the technical data and long term valuation data doesn’t look good right now. But even a generally expensive market, with a Shiller PE in the 23 to 24 range, has seen valuations much more stretched than they are at present, implying prospective long term returns are not at a century-long trough. But Mr. Hussman’s model isn’t based purely on valuations and he stresses the intermediate time horizon of his model’s prediction [for more economic news and analysis subscribe to our free newsletter].
Since we estimate prospective return/risk on a blended horizon of 2-weeks to 18 months, we are not making a statement about the very long-term, but only about intermediate-term horizons (prospective long-term returns have certainly been worse at some points, such as 2000). As always, our estimates represent the average historical outcome that is associated with a given set of conditions, and they don’t ensure that any particular instance will match that average. So while present conditions have been followed by extraordinarily poor market outcomes on average, there’s no assurance that this instance can’t diverge from typical outcomes. Investors should ignore my concerns here if they believe that the proper way to invest is to bet that this time is different.
Calling a market top is difficult to impossible, and it should be stressed that Mr. Hussman is not calling a market top here, but rather his model is predicting a poor range of outcomes, probability wise, for the market in the intermediate term. He generally advises against knee-jerk activity by long term buy-and-hold investors who have been successful with their discipline in the past. But it must be said, current valuations imply it may be a good time to take some gains. And in light of QE3, $1,700 ounces of gold don’t seem nearly as expensive as they did several months ago. Market weeks such as this one are generally poor ones to overhaul one’s investment strategy, but they are great times to review strategy, make tactical adjustments, and re-balance if necessary.
Disclosure: Author is long physical gold, IAU, VYM, and various US equities.