by John P. Hussman, Ph.D., Hussman Funds
On the treetop
When the wind blows
The cradle will rock
When the bough breaks
The cradle will fall
And down will come baby
Cradle and all
I’ve always thought that singing “Rock-a-bye baby” offers a bizarre lesson to our young, encouraging them to be lulled gently to sleep by describing a scene that should have them wide-eyed with terror. Let’s get this straight. You’ve got this baby, in a cradle, teetering on some fractured bough, at the top of a tree, complacently rocking with each breeze, with baby, cradle, and all facing an inevitable disaster that’s inherent in the situation itself. And everyone is OK with this.
You can see why I chose this song for this week’s market comment.
It’s important to start this discussion by emphasizing that we align our outlook with the prevailing evidence at each point in time. So for example, if a meaningful retreat in valuations was followed by a firming in our broad measures of market internals, our views would become at least moderately constructive even if stocks were still overvalued from a cyclical or secular standpoint. We remain flexible to new evidence.
Given the present evidence, however, my real concern is that much like the rolling tops of 2000 and 2007, each pleasant breeze here lulls investors into complacency – but in the face of overvalued, overbought, overbullish conditions that, from a cyclical and secular standpoint, should probably have them wide-eyed with terror (see Closing Arguments for a broad review of our concerns here). We can’t rule out that the bough will sway for a while longer despite the weight, but we won’t embrace the situation by putting our own baby on the twigs. It’s quite crowded up there already.
If you examine the 2000 and 2007 tops (and most market peaks outside of the “V-top” ones like 1987) you’ll notice the churn both before and after what turned out in hindsight to be the final peak. The S&P 500 experienced a correction of more than 10% in Jul-Oct 1999 that was then fully recovered, another 10% correction in Jan-Feb 2000 that was then fully recovered, another 10% correction in March-May 2000 that was fully recovered, and a final high in September after which the S&P 500 was cut in half. Likewise in 2007, a 10% correction in Jul-Aug was fully recovered by the October 9, 2007 peak, and the first 10% correction off the peak was followed by a 7% recovery into December before the market began to decline in earnest. Even then, once the market had lost 20% in March 2008, it mounted a nearly 12% advance by May 2008, as a further loss of more than 50% lay ahead.
It was this sort of rolling top, with intermittent corrections being followed by recoveries to yet further marginal highs, that prompted this quote from Barron’s magazine just before the 1969-1970 bear market plunge:
“The failure of the general market to decline during the past year despite its obvious vulnerability, as well as the emergence of new investment characteristics, has caused investors to believe that the U.S. has entered a new investment era to which the old guidelines no longer apply. Many have now come to believe that market risk is no longer a realistic consideration, while the risk of being underinvested or in cash and missing opportunities exceeds any other.”