A leading fund manager sees conditions in today’s market that presaged past plunges. A « perfect storm » lies ahead, adds a technical guru.
When practitioners who take distinctly different approaches to analyzing financial markets come to similar conclusions, it behooves investors to pay attention, even if those conclusions clash with yours. John P. Hussman, who puts his Ph.D. in economics to work by heading the eponymously named Hussman Funds, thinks that the present ranks among what he calls « A Who’s Who of Awful Times to Invest, » along with such unpropitious periods as 1973-74, 1987, 2000-02 and 2007-09.
Walter J. Zimmermann Jr., who heads technical analysis for United-ICAP, a technical advisory firm, puts it more succinctly: « A perfect financial storm is looming. »
Those dire forecasts contrast with the overwhelming bullish sentiment in the stock market. Indeed, that’s part of the problem indicated by Hussman’s criteria for a « Who’s Who, » which describes « the basic ‘overvalued, overbought, overbullish, rising-yields’ syndrome. » The criteria are:
• the Standard & Poor’s 500 trading at more than 8% above its 52-week exponential moving average
• the S&P 500 up more than 50% from its four-year low
• the « Shiller P/E, » based on the cyclically adjusted trailing 10-year earnings, developed by Yale economist Robert Shiller, greater than 18; it’s currently 22
• the 10-year Treasury yield higher than six months earlier
• the Investors Intelligence’s bullish advisory sentiment over 47%, and bearishness under 25%; in the latest data, the numbers were 47.9% bulls and 26.6% bears
WHEN ALL THOSE CONDITIONS OBTAIN, as they very nearly do now, look out below. In 1973, a 48% collapse ensued over 21 months, and in August 1987, there was a 34% plunge over the following three months. Since that ancient history, losses of 10% to 18% ensued in the 1998-2000 period, followed ultimately by a plunge of more than 50% in the dot-com bust of 2000-02. And in 2007, a correction of 10% culminated in the 50%-plus plunge of 2007-09 (see chart).
The Hussman Strategic Growth Fund (ticker: HSGFX), it’s worth noting, sidestepped the bursting of the dot-com bubble by actively hedging the fund’s equity positions. Its total return fell by just 21% from peak to trough in 2008, compared with a 35% decline for the S&P. However, it missed out on the subsequent rally, owing to a « defensive investment posture, » Hussman wrote in the fund’s annual report. Since the fund’s inception in July 2000 through the end of February, it had returned 94%, five times better than the 19%, including reinvested dividends, for the Standard & Poor’s 500 stock index over that doleful market span.
More recent selloffs also ensued in 2010 and 2011, although the latter decline was deferred by the Federal Reserve’s QE2 [quantitative easing, part two] securities purchases, Hussman writes. « Aggressive monetary policy did not prevent the ultimate declines, though massive central-bank interventions have undoubtedly helped to short-circuit the more violent follow-through that occurred in 1973-74, 1987, 2000-02 and 2007-09, at least to date, » he adds pointedly.
Hussman cautions that, while stocks sometimes immediately succumbed to the deadly combination of criteria, more often, they can hold up for weeks or even months, which frustrates those who stand aside or hedge while the averages make new highs.
« Even so, my greatest concern as an investment manager is the possibility that some number of our shareholders will grow so exasperated with remaining defensive during these periods that they capitulate and take a significant position in the market at the worst possible time, » he wrote.
« The completion of the present bull-bear market cycle (and it will be completed) will undoubtedly present strong opportunities to play offense, » Hussman concludes, « but today stands among a Who’s Who of the worst historical times to do so. Particularly for investors who do not have a large number of future cycles between now and the point they will need to draw significantly on their assets, a defensive stance is crucial here. »
That may not take much persuading if Zimmermann’s « perfect storm » blows through the stock market, which could happen imminently, he reckons.
The New York Stock Exchange Composite Index « looks poised to peak and reverse lower this week, » he warned in his weekly client letter on March 4. « All the essential ingredients for a major break lower are now in place. »
On the technical side, Zimmermann also cites the high level of bullish sentiment, plus waning relative strength and a negative formation on the charts called a « rising wedge. »
In an interview with Barron’s, Zimmermann adds that he watches the NYSE Composite as a gauge of American business, rather than measures such as the Dow Jones Industrials or the S&P 500, which are dominated by multinational giants, which, he quips are « countries with their own armies—of lawyers. »
THERE ARE AMPLE FUNDAMENTALS to knock the market down, including the well-advertised surge in gasoline prices, which Zimmermann calculates absorbed the discretionary spending power for half of America. And the escalating tensions over Iran’s nuclear program « is the gift that keeps on giving…if you like fear-inflated energy prices, » he wrote in the client letter.
At the same time, « the euro-zone response to their deflationary debt trap continues to be further loans to the hopelessly indebted, in return for crushing austerity programs.
So, evidently, not content with another mere recession, euro-zone leaders are inadvertently shooting for another depression. They may well succeed. »
The euro zone is (or was, he stresses) the world’s largest economy, and a buyer of 22% of U.S. exports, which puts the domestic economy at risk, he adds. Of course, this time may be different.
The Bottom Line
While many market watchers, including Barron’s, think that the recent rally still has legs, a confluence of signals suggests that we could see a sharp pullback in the next few weeks or months.
Monetary policies from nearly every major central bank around the globe are either already aggressively easy, like the Fed, the European Central Bank, the Bank of England and the Bank of Japan, or are in the process of easing, as is the People’s Bank of China.
So excess liquidity may continue to boost risk assets.
What’s less often mentioned is the likely severe fiscal tightening at the beginning of 2013, unless there is legislation to stave off big tax increases that kick in before the end of this election year.
Dividends, which have come back into fashion, would get taxed at ordinary-income rates as high as 39.6% next year, up from 15% currently. Capital-gains rates also are due to go up, to 20%, from 15%.
What usually roils markets is uncertainty. Absent legislative action, it’s certain that investors will be paying higher taxes. That would be enough to put the market at risk, even if it didn’t meet Hussman’s overbought, overvalued and overly bullish conditions, and even if the negatives cited by Zimmermann didn’t exist.
With the Standard & Poor’s 500 up 24% from the October lows, it may be a good time to take some chips off the table.