Roughly a month ago, Austin mentioned John Hussman in a post titled The Risks of Investing Based on Market Expectations. I was reminded of this post when I came across Hussman's latest commentary today, in which he states the current stock market bubble is beyond 1929 and 2007. Scary stuff.
“Make no mistake – this is an equity bubble, and a highly advanced one. On the most historically reliable measures, it is easily beyond 1972 and 1987, beyond 1929 and 2007, and is now within about 15% of the 2000 extreme. The main difference between the current episode and that of 2000 is that the 2000 bubble was strikingly obvious in technology, whereas the present one is diffused across all sectors in a way that makes valuations for most stocks actually worse than in 2000. “
However, I was also reminded of a post I wrote (Bearish? You Call That Bearish!?) about Hussman's latest view almost two full years ago, which was almost two full years after he had first turned bearish. Equally terrifying. But clearly waaay early.
Now it may seem like I'm piling on Mr. Hussman. Nothing could be further from the truth. The reason he tends to pop up here from time to time is because Austin and I find him one of the best-reasoned and plausible bearish voices around. He's not a nut — far from it. Rather, he's a walking object lesson of what can happen when you get a prediction right, but get the timing wrong. And by extension, a reminder why SMI doesn't invest based on predictions.
On the same side of the belief spectrum — the the Federal Reserve is in the process of inflating a massive bubble in equities that will eventually burst painfully — is Jeremy Grantham. We've relayed his views a few times in recent years as well (in part, because they've echoed my own "best guess" as to where the market would head). Grantham hasn't wavered in his expectation that this market is going to at least S&P 2250 before the bubble finally breaks (it's just under 2000 now, so that would imply at least another 13-15% gain).
He has added a few new thoughts as to why, however:
What is worse for us value-driven bears, a further bullish argument has struck me recently concerning the probabilities of a large increase in financial deals. Don’t tell me there are already a lot of deals. I am talking about a veritable explosion, to levels never seen before. These are my reasons. First, when compared to other deal frenzies, the real cost of debt this cycle is lower. Second, profit margins are, despite the first quarter, still at very high levels and are widely expected to stay there. Not a bad combination for a deal maker, but it is the third reason that influences my thinking most: the economy, despite its being in year six of an economic recovery, still looks in many ways like quite a young economy. ... Previous upswings in deals tended to occur at market peaks, like 2000 and 2007, which in complete contrast to today were old economic cycles already showing their wrinkles.
I think it is likely (better than 50/50) that all previous deal records will be broken in the next year or two. This of course will help push the market up to true bubble levels, where it will once again become very dangerous indeed.
My final thought on this issue is the following point, which I failed to make in my bubble discussion last quarter: perhaps the single best reason to suspect that a severe market decline is not imminent is the early-cycle look that the economy has. And even Edward Chancellor last quarter conceded that there was as yet no sign of a bubble in the quantity of credit that was being created.
My take on this bull market has been fairly simple for quite some time. The Fed has taken unprecedented monetary policy actions which have dramatically impacted (and continue to impact) the valuation of stocks. We've seen the boom-bust dynamic of past Fed cycles in the late 90s and mid-2000s, so we have some history to use as a guide. Given that their actions the past five years have been even more dramatic than before, I've expected an even bigger stock market response than before. We're moving toward that, but not there yet.
I've also expected that, as in the prior instances, the catalyst for the eventual undoing of the bull market will be when their monetary policy begins to sufficiently tighten to begin to hamper the economy. That hasn't happened yet either, which is why I've maintained that it seems likely this bull would continue.
That said, it was one thing to say that a couple years ago, or even in the spring of 2013. What about now? Well, first of all, we're not investing based on that prediction — it's simply an analysis of the current environment, a best guess as to what seems most likely. As such, it doesn't seem as though the key factors that have propelled this market for the last five years have changed. With those still intact, the probability seems to favor the market continuing to advance. To some degree, I think Grantham's take that the current economy still resembles the typical "early recovery" economy is thinking along these same lines. It would be a maturing economic environment that would cause the Fed to raise interest rates, which is the particular variable that I've been focused on.
Someone unfamiliar with SMI might read this and think we're just sitting idly by as a stock market bubble inflates, knowing it will eventually blow up in our faces. That's not the case. We do expect the Hussman's of the world will be proven correct (eventually) and that there will be a bear market after this bull market. I've written before that it will likely be a nasty one, given the proportions of the bullish excess I've expected would precede it.
But as our introduction of Dynamic Asset Allocation last year makes clear, we're not simply waiting for it to hit us in the teeth. We think DAA will give us the best tool we've ever had to deal with an oncoming bear market.
Just as importantly, it's also given us a tool that has allowed us to stay invested as this bull market has rolled along, knowing there was a built-in safety mechanism already in place. That's worth a lot, as those who enjoyed Upgrading's 30%+ returns last year or Sector Rotation's huge gains the past couple years will attest.