Hussman Weekly Market Comment: Unusual Drawdown Risk
Of course, our present concerns are based on a smaller and more negative subset of conditions that we've seen even less frequently - presently featuring not just "overvalued" and "overbought" conditions, but adding overbullish sentiment, modest but clear upward pressure on short-term and some longer-term yields, and an "exhaustion syndrome" (a combination of "whipsaw" conditions coupled with falling earnings yields - see Goat Rodeo ), which have historically had a particularly hostile aftermath, including a small set of historical plunges that include 1987, 2000 and 2008.
Notably, these conditions are independent of economic concerns. They are based on factors that have reliably identified elevated market risk without the necessity of concurrent economic strains. That said, while we certainly recognize the recent improvement in economic data, that improvement remains "low level" in that we continue to view the economy as vulnerable to even mild additional shocks. During mid-2011, consumption and production activity fell back, as consumers and businesses put off spending plans based on the flaring credit strains in Europe. Following the coordinated easing and 3-year liquidity operations of the ECB and other central banks, a collective sigh of relief became clearly observable in a burst of pent-up economic activity in recent months. It is still very unclear that this is a sustained or sustainable improvement, and even the latest data from the OECD leading indicators last week did not do much to ease our broad economic concerns.
From an economic perspective, then, we remain generally concerned, as the leading evidence has not improved enough to take the risk of a fresh economic downturn "off the table" - but we are also realistic about the improvement in the general trend of recent months. It may or may not be thin ice, but people are skating on it for now, and there's no denying that.
From an investment perspective, however, it's important to underscore that economic concerns are not the driver of our present defensiveness. We've seen a handoff from negative leading economic indicators to much more general "overvalued, overbought, overbullish" conditions. Either one alone is a headwind, a high-risk condition does not require both, and the vast majority of history has featured neither.
The bottom line is that near-term market direction is largely a throw of the dice, though with dice that are modestly biased to the downside. Indeed, the present overvalued, overbought, overbullish syndrome tends to be associated with a tendency for the market to repeatedly establish slight new highs, with shallow pullbacks giving way to further marginal new highs over a period of weeks. This instance has been no different. As we extend the outlook horizon beyond several weeks, however, the risks we observe become far more pointed. The most severe risk we measure is not the projected return over any particular window such as 4 weeks or 6 months, but is instead the likelihood of a particularly deep drawdown at some point within the coming 18-month period.
