‘Running toward the fire’: One expert explains how investors have created a scenario where a 50% market crash is ‘optimistic’

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John Hussman — the outspoken investor and former professor who’s been predicting a stock collapse — argues that catastrophe will strike the market because of a crucial misunderstanding around the impact of monetary easing.
Hussman supports his overall bearish thesis by pointing out valuation metrics that are way out-of-whack and extraordinary central bank policies he finds troubling.
He also reiterates his call for a 60% to 65% stock market crash.
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When stocks hit new all-time highs, conventional wisdom suggests that investor euphoria should be permeating far and wide.

After all, the Federal Reserve has signaled it will cut rates later this month, a practice historically associated with further equity-market gains.

Yet although many market participants are surely elated with their returns, others prefer to look at that euphoria as a sign that sentiment is overheated.

John Hussman, president of Hussman Investment Trust, sits firmly in that camp. He has once again reiterated his belief that the market is trading on borrowed time. And, in typical fashion, he’s not sugarcoating his prognostications when it comes to the US stock market’s future.

"Presently, we observe market conditions that have been associated almost exclusively, and in most cases precisely, with the most extreme bull market peaks across history," he wrote in a recent blog post.

At the core of Hussman’s main argument in the post is the idea that monetary easing is only a boon for stocks when market sentiment is positive. Noting that internals have recently tilted negative, the renowned market bear thinks investors are missing an extremely important factor: the direct correlation between Fed interest rate cuts and periods of economic strife during previous similar instances.

"While investors appear exuberant about the prospect for Fed easing, they seem largely unaware that initial Fed easing have almost invariably been associated with US recessions," Hussman said. "They’re running toward the fire."

And he thinks investors are about to get burned.

Hussman continued: "With the exceptions of 1967 and 1996, every initial Fed easing (ultimately amounting to a cumulative cut of 0.5% or more, following a period of tightening in excess of 0.5%), has been associated with a US economic recession," he said, providing a stark historical backdrop for his assessment.

But the Fed isn’t the only thing Hussman is worried about. To further his thesis, he points to valuation metrics that are way out-of-whack.

The first red flag compares market capitalization (nonfinancial) to corporate gross value-added (nonfinancial). It’s now trading at an end-of-cycle multiple higher than any other in history.

Hussman

Beyond that, Hussman depicts the margin-adjusted price-to-earnings ratio, which is analogous to a market-wide price-to-revenue ratio. He notes it’s also teetering towards nosebleed levels.

Hussman

Put simply, according to Hussman, valuations are lofty — and instead of cheering the Fed rate cuts, investors should be heading for the hills.

He goes on to refer to a 50% market loss as "a rather optimistic scenario," and continues to expect a decline between 60% and 65%.

"You have to decide whether to look like an idiot before the crash, or look like an idiot after it," Hussman concluded.

Hussman’s track record

For the uninitiated, Hussman has repeatedly made headlines by predicting a stock-market decline exceeding 60% and forecasting a full decade of negative equity returns. And as the stock market has continued to grind mostly higher, he’s persisted with his calls, undeterred.

But before you dismiss Hussman as a wonky permabear, consider his track record, which he breaks down in his latest blog post. Here are the arguments he lays out:

Predicted in March 2000 that tech stocks would plunge 83%, then the tech-heavy Nasdaq 100 index lost an "improbably precise" 83% during a period from 2000 to 2002
Predicted in 2000 that the S&P 500 would likely see negative total returns over the following decade, which it did
Predicted in April 2007 that the S&P 500 could lose 40%, then it lost 55% in the subsequent collapse from 2007 to 2009

In the end, the more evidence Hussman unearths around the stock market’s unsustainable conditions, the more worried investors should get. Sure, there may still be returns to be realized in this market cycle, but at what point does the mounting risk of a crash become too unbearable?

That’s a question investors will have to answer themselves. And it’s one Hussman will clearly keep exploring in the interim.

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Source: Business Insider – ccompetiello@businessinsider.com (Christopher Competiello)