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John Hussman calls equity markets “a textbook pre-crash bubble”

One of Wall Street's most outspoken bears decides to growl - but is he just stuck in the wilderness?

When he was younger, Max Fawcett wanted to make a mint in the markets. Now as the managing editor of Alberta Venture he gets to write about them. Close enough, right? He can be reached at mfawcett@albertaventure.com

Nov 27, 2013

by Max Fawcett

Among John Maynard Keynes’s many famous observations, the most topical right now might be that equity markets can remain irrational longer than you can remain solvent. And if you don’t believe it, just ask John Hussman, the eponymous head of Hussman Funds and a man who’s been calling for global equity markets to correct – or crash – since 2011. Earlier this month, he referred to the stock markets as being in a “textbook pre-crash bubble,” and took aim at incoming federal reserve chair Janet Yellen’s assertion that they’re not.

In his latest letter to shareholders, Hussman writes that “the reason that the Fed does not see an “obvious” stock market bubble is because while price/earnings multiples appear only moderately elevated, those multiples themselves reflect earnings that embed record profit margins that stand about 70 per cent above their historical norms. We can demonstrate in a century of evidence that a) profit margins are mean-reverting and inversely related to subsequent earnings growth, b) margin fluctuations are largely driven by cyclical variations in the combined savings of households and government, and importantly, c) valuation measures that normalize or otherwise dampen cyclical variation in profit margins are dramatically better correlated with actual subsequent outcomes in the equity markets.”

His prescription? Put an end to quantitative easing – now. “It undermines planning, as every economic decision must be made in the context of what the Federal Reserve may or may not do next. It starves risk-averse savers, the elderly, and the disabled from interest income. It lowers the bar for speculative, unproductive, low-covenant lending (as it did during the housing bubble). It relaxes a constraint that is not binding – as there are already trillions of dollars in idle reserves at U.S. banks, on which the Federal Reserve pays interest both to keep them idle and to avoid disruptions in short-term money markets. It undermines price signals and misallocates scarce savings to speculative pursuits. It further skews the distribution of wealth, and while the extent of this skew has a scarce chance of persisting, the benefits of any spending from transiently elevated stock market wealth will accrue to primarily to higher-income individuals who are not as constrained as the millions of lower-income, low-asset families hoping for some “trickle-down” effect. We have seen numerous variants of this movie before, and we should have learned the ending by now.”

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Of course, Hussman has been saying this for the better part of three years now. In the spring of 2011, he described stocks as being part of “a strenuously overvalued, overbought and overbullish equity market.” And while the S&P 500 has raced up 30 per cent in the last year and 50 per cent in the last three, Hussman’s Growth Fund has delivered returns of -6.3 and -7.4 per cent respectively. His call to end QE, meanwhile, is at odds with a growing host of economists – Paul Krugman, Greg Mankiw, Ken Rogoff – who are saying that the Fed should be stepping on the gas rather than easing off the pedal. Rogoff even went so far as calling for six per cent inflation for a few years in a recent speech in order to help the state and its citizens deleverage more easily and effectively.

Still, when it comes to calling bubbles, Hussman’s track record is impressive – he nailed the last two, after all. But even if markets finally heed his call for a 40 to 50 per cent correction, that would still leave his investors lagging the returns of those who simply piled into equities and held their breath these last few years.

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