Stock Market Collapse A Distinct Possibility – Here’s Why

Every speculative bubble convinces investors that the world has changed in ways that make basic arithmetic irrelevant.

This post (717 words) contains excerpts from an excellent, albeit lengthy (6,245 words), original article by John Hussman. Highlighted (blue) and capitalized words have been added by munKNEE.com for emphasis.

“A remarkable feature of extended bull markets is that investors come to believe – even in the face of extreme valuations – that the world has changed in ways that make steep market losses and extended periods of poor returns impossible. Among all the bubbles in history, including the 1929 bubble, the late-1960’s Go-Go bubble, the early 1970’s Nifty-Fifty mania, the late-1990’s tech bubble, and the 2007 mortgage bubble that preceded the global financial crisis, none has so thoroughly nurtured the illusion that extended losses are impossible than the bubble we find ourselves in today…

Presently, we are at the most optimistic point of the most overvalued market bubble in the history of the nation. The S&P 500 is at a rare point of overextension relative to its 40-week and 200-week averages, in the context of deterioration and divergence in our key gauge of internals, indicating that the market is dangerously narrowing, in a way that reflects emerging risk-aversion.

This bubble has been built on near-universal confidence that serious market losses can be ruled out, and that in Ben Graham’s words “any setbacks will be made up speedily.” Couple lopsided bullish sentiment with record margin debt relative to GDP, and you now have an “all-in” market. Unfortunately, that’s also a market where the first question speculators will hear as they enter their sell orders will be – “To whom?”

Speculation versus investment

Don’t kid yourself.

• If you’re fully invested in stocks here, you’re a speculator.
• If your exposure to stocks doesn’t meaningfully take account of valuations here, you’re a speculator.
• Now, there can be intelligent speculation, but there can also be reckless speculation. If your speculation is based primarily on the fact that prices have gone up in the past, it’s very likely that you’re speculating recklessly.

As Graham & Dodd observed in 1934, investment means buying a security at a valuation that is associated with a reasonable expectation of acceptable long-term returns, based on a careful analysis of the relationship between the current price and expected future cash flows. Speculation means buying a security in the expectation that its price will advance.

In my view, intelligent investment requires careful consideration of:

• the arithmetic that links current prices with future cash flows; and the historical evidence that relates reliable valuation measures to subsequent returns.
• the condition of investor psychology as well as
• the extent, if any, that prices are compressed in a way that provides them substantial room to run.

The best possible situation is, of course, when market conditions provide both investment merit and speculative merit – a combination of undervaluation, price compression, and early improvement in market internals. I expect that even the coming quarters will provide good opportunities for rational speculation (mostly likely with a safety-net) well before we see this full combination, and that’s fine.

In any event, the worst possible situation is when market conditions provide neither investment merit nor speculative merit – a combination of hyper-valuation, price over-extension, and early deterioration in market internals. In my view, investors presently face the worst possible situation.

No forecasts are required

My impression is that the first leg down from recent market highs may be nearly vertical. Given that current extremes eclipse the dizziest heights of both 1929 and 2000, I suspect that a 30% down-leg in the S&P 500 from current extremes wouldn’t even break a sweat. The real question is how many further 20-30% losses may occur after consolidations and rallies. On that, I have no particular expectation. We could see a 1987 or 1998 type of “panic” decline, where the market experiences a vertical loss and speculators take the bit in their teeth again, or a decline could evolve into something more extended. The extended ones typically become intertwined with economic and credit disruptions, in which case the typical outcome is a whole series of steep losses punctuated by extended recoveries and then fresh declines. We’ll take the evidence as it comes.

Put simply, I believe that current risks are unusually pointed, and warrant a rare degree of seriousness… A century of market history suggests that major losses are already effectively baked into current hyper-valued extremes…”

Editor’s Note:  The above version of the original article by John Hussman, has been edited ([ ]) and abridged (…) for the sake of clarity and brevity to ensure a fast and easy read.  The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article.  Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor. Also note that this complete paragraph must be included in any re-posting to avoid copyright infringement.

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