Hussman Weekly Market Comment: Rock, Paper, Scissors

It will come as no surprise that market conditions remain of great concern here. As always, but particularly now, it’s important to stress that our defensiveness is a reflection of prevailing, observable evidence and the alignment of our investment views with the average outcome of such evidence across similar instances over the course of history. The consistency of negative outcomes also worsens the expected return/risk ratio presently. A defensive stance here does not require any particular forecast about recession, profit margins, bubble/crash dynamics, QE, European banking strains, or any of the numerous risks in the economic and financial backdrop. All of these factors are worthy of discussion in their own right. Still, our approach is always to align our investment stance with the average return/risk profile that is associated with a given set of market conditions, placing heavy weight on valuations, market action (e.g. trend-following factors, market internals, measures of overextension, price/volume behavior), as well as monetary factors, sentiment, economic measures and other considerations. See Aligning Market Exposure with the Expected Return/Risk Profile for a review of this general approach.

My concerns here are not based on a forecast about any particular event in this specific instance. It is based on an ensemble of observable factors that can be tested and validated across numerous independent samples of market history over time, and the average profile of market return and risk produced by instances that share the same central features. Every instance matching the present one on central features (which in this case include the 1929 peak, the late-1972 euphoria as gold-linked monetary policy was abandoned, the 1987 pre-crash peak, the 2000 peak of the tech bubble, and the 2007 peak of the credit bubble) has also had other features that never before and will never again be observed in exactly the same way. That’s the reason for validating those central features against numerous independent samples of history. In some respects, this time is always different. But on the central features that have regularly been associated with the worst market outcomes – namely the acute syndrome of overvalued, overbought, and overbullish conditions that we presently observe – this time has never been different.

To the extent that we align our investment stance with the average return/risk profile, one might reasonably say that we are relying on the belief that this profile is representative of the most likely range of outcomes in the current instance. But that still does not require a specific forecast. To see the difference, suppose you have a pair of dice and a combined roll of 7 or 11 gets a payoff. Now suppose that the “6” faces on both of the dice are wiped off, and replaced with a “1.” There are still a few ways to win, but the return/risk profile has changed. One does not need to forecast the next specific roll to understand that the prospect of winning further bets has declined significantly.

For investors, the prospect of winning further bets has declined significantly.