Iron Law of Valuation

John Hussman on what’s been brewing for some time:

The way to understand the bubbles and collapses of the past 15 years, and those throughout history, is to learn the right lesson. That lesson is not that overvaluation can be ignored indefinitely – we know different from the collapses that have regularly followed extreme valuations. The lesson is not that easy monetary policy reliably supports stock prices – persistent and aggressive easing did nothing to keep stocks from losing more than half their value in 2000-2002 and 2007-2009. Rather, the key lesson to draw from recent market cycles, and those across a century of history, is this:

Valuations are the main driver of long-term returns, but the main driver of market returns over shorter horizons is the attitude of investors toward risk, and the most reliable way to measure this is through the uniformity or divergence of market internals. When market internals are uniformly favorable, overvaluation has little effect, and monetary easing can encourage further risk-seeking speculation. Conversely, when deterioration in market internals signals a shift toward risk-aversion among investors, monetary easing has little effect, and overvaluation can suddenly matter with a vengeance.

As Hussman has been noting for the last 6-mos or so, internals did not support valuations. All that supported them was sentiment.   With sentiment slipping, the veil is quickly pierced and reality comes spilling forth.

Or as Vigilant Investor used to put it in 2005-2007, we don’t know exactly when the day of reckoning will happen, but it will come — and suddenly — when a critical mass of investors reaches their Wil E Coyote point and decides to pause and look down to see the road turned some time ago and there is nothing below to support their old perception of value.

Look out below!

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