Hussman Weekly Market Comment: Investment, Speculation, Valuation, and Tinker Bell

Stocks remain in a mature – but not obviously complete – bull market, with the S&P 500 a stone’s throw away from its 2007 record high of 1565. In the midst of it all, investors face a confusing mix of arguments – some that stocks are significantly undervalued, some that they are dangerously elevated; some that sentiment is overly defensive, some that it is overly euphoric.

The most important questions investors should be asking are these: what do they know that can be demonstrated to be true; and what do they believe that can be demonstrated to be untrue. It is best to make these distinctions deliberately, lest the financial markets clarify these distinctions for investors later, against investors’ will, and at great cost. That’s not to say that understanding these distinctions will ensure investors the correct short-term stance in the market. More likely, though, it will help investors to distinguish good investment opportunities from poor ones. Even in the event the present bull market advance has a long way to go, it will also help to distinguish good speculative opportunities from poor ones.

Let’s begin with an observation. Not a prediction, but merely an observation. Last week, Investors Intelligence reported that the percentage of bearish investment advisors has declined to just 18.8%. The last time bearish sentiment was below 20%, at a 4-year market high and a Shiller P/E above 18 (S&P 500 divided by the 10-year average of inflation-adjusted earnings – the present multiple is 23) was for two weeks in May 2007 with the S&P 500 about 1525. The next instance before that was two weeks in August 1987 (bearish sentiment never dipped much below 27 approaching the 2000 peak except for a reading of 22.6 in April 1998, just before the Asian crisis). The next instance before that was for 3 weeks of a 5-week span in December 1972 and January 1973, which was immediately followed by a 50% market plunge. There are a handful of observations in March-May 1972 at a slightly lower level that were punctuated by a modest market decline before the final advance to the late-1972 peak (that lag is enough to discourage any near-term conclusions in the present instance). The instance before that was in February 1966, which was promptly followed by a bear market decline over the following year. You get the picture.

Again, these are observations. Frankly, I’m about as exhausted with such observations as you are. The problem is that particularly since March 2012, our estimates of prospective market returns (on a blended horizon of 2-weeks to 18 months) have moved from the worst 2% of historical observations, to the worst 1% of observations, to what is now such rarified air that only a handful of atoms remain. Still, markets are driven by beliefs, and so long as those beliefs are not challenged by anything to derail them – even if they ultimately prove incorrect – the markets may very well create their own reality for a while.

Speculation and Investment

We generally distinguish speculation from investment. For us, investment is buying a security at a price that is associated with a reasonable expectation of acceptable long-term returns. Speculation is buying a security in the expectation that its price will advance, with less regard for long-term prospects. Both benefit from solid valuation methods and reliable measures of market action, but investment weighs valuation more strongly, while speculation weighs market action more strongly. The problem for active market participants is to distinguish between investment and speculation in the first place, and then to identify good and bad opportunities to accept such positions.