With the US sharemarket trading at its highest level since May 2008 overnight, funds manager John Hussman argues that investors should be asking themselves one simple question: ‘Do I feel lucky?’
In his latest research note, Hussman, who runs Hussman Funds, argues that at present levels the US stockmarket is not priced to achieve reasonable investment returns (he estimates the S&P will likely achieve a 4.3 per cent annual total return over the next decade, amid a lot of volatility). What’s more, he argues, market risk is not even attractive on a speculative basis, given the combination of overbought conditions and overbullish sentiment.
"Then again, what keeps slot machines spinning all around the world is the hope – despite the predictably and reliably negative average return/risk trade-off – that this time will be different, and this spin will work out," he says. "So you have to ask yourself one question. Do I feel lucky?"
Hussman has developed a warning signal for markets that are overvalued, overbought and overbullish. The signal flashes when the S&P 500 is trading at more than 8 per cent over its moving average, and has climbed more than 50 per cent from four-year lows, when price-to-earnings averages are greater than 18, investors are extremely bullish, and US bond yields are higher than they were six months earlier.
When these conditions are in place – as they nearly are now – investors should expect trouble. In 1973 there was a 48 per cent collapse over 21 months, and in August 1987 there was a 34 per cent plunge. There was a 50 per cent drop in the dot-com collapse of 2000-2, followed by a drop of more than 50 per cent in the financial crisis that started in 2007.
In his latest note, Hussman points to an alarming recent development: corporate insiders now appear to be dumping their stocks. According to Investors Intelligence, corporate insiders are now selling shares at levels associated with "near panic action”. Company executives usually get shares as part of their compensation, and so it’s usual for them to sell two shares on market for every share they purchase outright. Recently, however, insider sales have recently been running at a pace of eight to one. Another measure from TrimTabs shows that corporate insiders have recently been selling $13 of stock for every $1 of purchases.
According to Hussman, "some of the weekly spikes have been to levels that are associated almost exclusively with intermediate market peaks, the most recent being the run-up to the 2007 market peak, the early 2010 peak and the 2011 peak, all of which resulted in significant intermediate corrections or worse.”
Of course, corporate insiders sometimes sell early and miss out on the last tail of a market rally, so investors may decide to ignore the heavy pace of insider selling for a while. But Hussman argues that they’re pushing their luck.
"We don't believe that this is a good time to take significant market risk in hopes of getting lucky. On an objective basis, we identify present conditions among the lowest 1.5 per cent of historical periods in terms of overall return/risk profile. Maybe investors will get lucky, but the odds are still unfavourable.”
Hussman argues that investors and economists have been too quick to abandon concerns about a fresh US economic downturn. He points out that we’re now seeing a disturbing divergence. The reliable leading indicators (which point to where the US economy will be in several months’ time) are actually deteriorating. But the coincident measures (which point to where the economy is at present) are more upbeat, which is fuelling the general optimism.
Unfortunately, as Hussman notes, when such divergences have appeared in the past the leading indicators have been proven correct.
Hussman argues that there was a clear improvement in the US leading indicators in the period between September and November, which he attributes to the European Central Bank’s massive lending program at the end of last year. And this has been reflected up in US economic figures on employment, spending, consumer confidence and growth.
Since then, however, the leading indicators have turned down badly, and are now worse than they were last July. As a result, Hussman warns that we should brace ourselves for worse than expected US economic figures over coming months.