Our Secular Trend Score (STS) and Cyclical Trend Score (CTS) are calculated using a large basket of fundamental, technical, internal and sentiment data. The historical data used by our models extend back to the market crash in 1929 and have enabled our STS to correctly identify every secular inflection point and our CTS to correctly identify more than 90 percent of all cyclical inflection points during the last 85 years. Additionally, when analyzed collectively, these data identify extremes in the risk/reward profile of the stock market from an investment perspective. Since early 2013, stock market investment risk has remained in the highest one percentile of all historical observations, and the latest speculative surge during the last year has increased overall risk to one of the highest levels ever recorded, joining a select group of three time periods that includes the long-term tops in 1929 and 2000.
As we often stress, this particular measurement of investment risk is not a top call or an indication that a severe market decline is imminent. Overbought rallies such as this one can remain overbought for a long time as speculative momentum carries prices to higher and higher extremes. What the current investment risk/reward profile tells us is that a severe market decline will almost certainly occur after the current cyclical bull market terminates. In his latest weekly commentary, fund manager John Hussman reviews another data set that indicates stock market valuations have now exceeded those at the previous bubble peak in 2000. We have included an excerpt from his commentary below, although we would highly recommend reading the entire article.
At bull market peaks, investors typically fail to recognize cyclically elevated profit margins, assuming that those margins are permanent and that earnings can be taken at face value. If there is one thing that separates our views here from the bulk of Wall Street analysis, it is the historically-informed insistence that investors are mistakenly banking on record-high profit margins to be permanent. For more on this, including evidence that historical profit margin dynamics remain quite on track and have not changed a whit, see The Coming Retreat in Corporate Earnings, and An Open Letter to the FOMC: Recognizing the Valuation Bubble in Equities.
While the evidence may be alarming to some, make no mistake: The median price/revenue multiple for S&P 500 constituents is now significantly higher than at the 2000 market peak. The average price/revenue multiple across S&P 500 constituents is now above every point in that bubble except the first and third quarters of 2000. Only the capitalization-weighted price/revenue multiple – presently at about 1.7 – is materially below the price/revenue multiple of 2.2 reached at the 2000 peak. That’s largely because S&P 500 market capitalization was dominated by high price/revenue technology stocks in 2000. [Geek's Note: as a result, if one chooses a universe of stocks by first sorting by market capitalization, one will probably find that price/revenue multiples of those stocks are lower today than in 2000]. Regardless, the historical norm for the capitalization-weighted S&P 500 price/revenue ratio is only about 0.80, less than half of present levels. The fact is that unless current record-high profit margins turn out to be permanent, against all historical experience to the contrary, the overvaluation of the broad equity market is equal or more extreme today than it was at the 2000 bubble peak.
Bill Hester and Jeff Huber here at Hussman Strategic Advisors compiled the chart below using point-in-time constituents of the S&P 500 Index each quarter since 1990. Investors often forget that smaller stocks struggled during the final years of the bubble as investors clamored for glamour. Again, the broad stock market was much more reasonably valued in 2000 than it is today, as extreme valuations were skewed among the largest of the large caps. Not anymore. The Federal Reserve has stomped on the gas pedal for years, inadvertently taking price/earnings ratios at face value, while attending to “equity risk premium” models that have a demonstrably poor relationship with subsequent returns. As a result, the Fed has produced what is now the most generalized equity valuation bubble that investors are likely to observe in their lifetimes.
As a reminder of where capitalization-weighted valuations stand, the following chart shows the present ratio of market capitalization to GDP (shown on an inverted scale on the left, so richer valuations are lower on the chart). Actual subsequent 10-year S&P 500 total returns are plotted in red (right scale). Any belief that present levels represent a “zone of reasonableness” is detached from the historical evidence. The entire market does not deserve to be viewed as a wide-moat Buffett-type stock where earnings can be relied on as a sufficient statistic of value.
All of this said, I would be remiss if I did not emphasize that valuation is not a timing tool. We have a strong expectation that stocks will achieve weak total returns over the coming decade, and negative total returns over horizons shorter than about 7 years. But as the investment horizon shortens to less than a few years, other factors become more important in determining market returns.
I’ve historically encouraged buy-and-hold investors to maintain their own investment discipline, though with a realistic and historically-informed understanding of prospective return and risk. At present, my concern is that many buy-and-hold investors are unaware of how dismal prospective returns are likely to be from current prices, over every investment horizon of a decade or less. Given the duration of the equity market (which mathematically works out to be roughly the market price/dividend multiple), a passive 100% exposure to equities is appropriate only for investors with a horizon of about 50 years. Passive buy-and-hold investors would be well-advised to scale their equity exposures accordingly, based on their own actual investment horizons. Meanwhile, it seems clear that investors have mentally minimized their concept of potential downside, despite two 50% bear market losses in recent memory that were both accompanied by aggressive Fed easing all the way down.
At present, the picture below is just a monthly chart of the S&P 500 since 1995. Not long from now, perhaps less than 2 or 3 years, many investors will look at the same chart with their head in their hands, asking “What was I thinking?” The central message to investors with unhedged equity positions and investment horizons shorter than about 7 years: Prospective returns have reached zero. The value you seek from selling in the future is already on the table today. The future is now.
We have avoided taking the difficult steps that will ultimately be required to heal our economy and lay the foundation for the next structural growth cycle. Instead, we continue to buy time via short-term measures. Although the recent quantitative easing programs have not meaningfully addressed the structural problems that are weighing on our economy, they have successfully inflated the stock market, creating yet another massive bubble. Unless this time is different, and the fundamental nature of the business cycle has somehow been changed, the current stock market bubble will end as badly as all previous bubbles. It remains to be seen what form the catalyst for the bubble implosion will take, and it is usually something that conventional thought had not been expecting. However, it is not a matter of if the bubble will burst, but when.
Fueled by a historic amount of stimulus from the Federal Reserve, the cyclical bull market in stocks that began in 2009 has accelerated into an unsustainable advance, causing investment risk to increase to one of the three highest readings during the past 85 years.
Following the low in 2010, the stock market rally has exhibited the characteristics of a classic bubble as defined by a log periodic advance. The violent decline in January was a meaningful breakdown, signaling that the bubble may have begun the topping process. Since then, short-term market moves have become increasingly violent. When it occurs during the final phase of a highly irrational advance, this type of behavior is usually indicative of speculative exhaustion.
From a short-term perspective, the decline last week favors the development of another violent downtrend heading into the next meaningful short-term low. On April 4, our cycle analysis identified the formation of the latest alpha high (AH). Additionally, we noted that a quick move below the short-term cycle low (STCL) in late March would signal the likely transition to a bearish translation. Since the formation of the AH, stocks have moved well below the last STCL, confirming the transition to a bearish short-term translation and favoring additional weakness heading into the next STCL in late May.
Looking ahead, if an extended alpha phase decline is followed by a weak beta phase rally and an extended beta phase decline, the new bearish translation would be reconfirmed and additional short-term weakness would be forecast in June and July.
Alternatively, an extended beta phase rally that returns to recent long-term highs followed by a beta phase decline that holds well above the forthcoming beta low (BL) would suggest that cycle translation is in question.
As always, these scenarios are approximations that represent the most likely possibilities identified by our computer models and actual price behavior will likely deviate from both. However, note that both scenarios suggest the current environment of extreme volatility is likely to continue for at least the next several weeks. From an intermediate-term perspective, the decline last week moved the S&P 500 index well below support at the lower boundary of the uptrend from 2011. Additional weakness next week would confirm this breakdown on the weekly chart and strongly favor the bearish short-term scenario that was outlined above.
As we often note, a cyclical top is a process, not an event. A confirmed breakdown on the weekly chart would be a significant technical signal, and market behavior during the next several weeks will determine if the next cyclical bear market is likely commencing.
Context plays a vital role in the development of reliable market forecasts. Short-term price behavior only has meaning when analyzed in the proper context afforded by the long-term view, so all investing and trading strategies should begin with a thorough understanding of the current secular environment. There have been five secular trends in the stock market since the crash in 1929, three downtrends and two uptrends.
The current secular bear market began in 2000 following a speculative run-up during the second half of the 1990s. As usual, market behavior clearly signaled that a secular inflection point was approaching and our Secular Trend Score (STS), which analyzes a large basket of fundamental, internal, technical and sentiment data, issued a long-term sell signal in December 1999. At the time, our computer models predicted that stocks would enter a secular bear market that would last from 10 to 20 years. Following the topping process in 2000, a prototypical secular downtrend began that continues today.
Severe secular bear markets such as this one are nearly always accompanied by extremely weak economic activity and the first decade of this century was characterized by the lowest real GDP growth since the Great Depression.
Stock market secular trends typically last from 10 to 20 years, depending upon the nature of underlying structural economic trends. Since we are currently in the final stage of a debt expansion cycle that began 60 years ago, it is highly likely that the current secular bear market is still several years away from its terminal phase.
The STS supports the hypothesis that this secular downtrend is far from over as the score has yet to return to positive territory following the sell signal in 1999. Secular inflection points develop slowly, usually over the course of 6 to 12 months, so the STS will provide plenty of advance warning when the next true investment opportunity develops in the stock market.
Secular trends are themselves composed of cyclical subcomponents, and the current cyclical uptrend began in March 2009. At a current duration of 60 months, the bull market from 2009 is long overdue for termination and it will likely be followed by a violent overbought correction.
The final phase of the previous cyclical bull market from 2002 was easy to identify as it developed in 2007. The measured move higher from 2004 until 2006 was followed by a speculative blow-off rally that terminated the advance. The historic amount of Federal Reserve stimulus introduced during the last four years, targeted directly at risk assets such as stocks, has created massive market distortions, causing the current cyclical bull to be characterized by violent moves in both directions. However, the last advance off of the low in 2011 is rising at an unsustainable rate, suggesting that the rally has entered its final phase.
Another way to model an unsustainable advance is via a log periodic bubble. This mathematical formula replicates market behavior extremely well during highly speculative uptrends and the following chart displays the high degree to which the current stock market rally is exhibiting the characteristics of a prototypical bubble. The recent sharp decline in January was a meaningful breakdown at this phase in the development of the bubble, and another decline of similar character sometime during the next several weeks would strongly suggest that the top is forming.
Additionally, it is important to remember that stock market investment risk continues to hold near the highest level ever recorded, and the latest advance has caused investment risk to increase to one of the three highest readings during the past 85 years.
Anything can happen over short-term time periods, but the key to having consistent success over the long run as an investor and a trader is to stay aligned with the most likely scenarios and protect yourself from the unlikely ones. There will come a time when the risk/reward profile of stocks is once again favorable and the judicious study of market data will signal when that next long opportunity develops, just as it did in March 2009. However, now is a time for extreme caution and we remain fully defensive from an investment perspective.
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During the past year we have been tracking the development of a log periodic bubble in the stock market, and the recent breakdown in January suggests that the bubble may have finally popped. As we often stress, a long-term top is a process, not an event, so it is too soon to conclude with a high degree of statistical confidence that a cyclical top is in place. However, stock market behavior during the past year bears a strong resemblance to the behavior at notable bubble tops of the past 100 years. In his latest weekly commentary, fund manager John Hussman reviewed the potential topping pattern and compared it to similar bubble tops in 1929, 1973 and 2000. We have reprinted an excerpt from the Hussman commentary below.
To offer some perspective of how major peaks have typically evolved, the following charts present the Dow Jones Industrial Average in the final advances toward, and the few weeks after, what turned out in hindsight to be major stock market peaks. For reference, let’s examine the recent market peak. Notice several features:
A series of moderately spaced peaks forming a broad sideways “consolidation” over several months;
A breakout from that consolidation, leading to a steep and only briefly corrected speculative blowoff into the market’s peak;
A steep initial selloff from the market peak, and finally;
A “reflex” rally (classically on low volume – indicative of a short-squeeze with sellers backing off) that retraces much of the initial selloff.
One can observe that same general dynamic in the chart below – a series of moderately-spaced peaks forming a largely sideways consolidation, a breakout to a steep and only briefly corrected speculative “blowoff”, an initial retreat, and finally a reflex rally. This chart depicts the final advance to the 1929 market peak.
Largely the same dynamic was evident in the advance to the 1973 peak (after which the market lost half its value into late-1974): a series of moderately-spaced peaks comprising a broad consolidation, a breakout to a steep and only briefly corrected speculative blowoff and market peak, a steep initial decline, and a short-lived reflex rally after the peak.
As it happens, the sequence described here is not at all new. Instead, it follows a pattern that technical analyst George Lindsay described in 1970 (and notably before even the 1973 instance above), which he called “Three Peaks and a Domed House.” Lindsay observed this pattern repeatedly across historical market cycles, describing about half of the bull market tops in the DJIA.
My sense is that it is enormously ambitious to label 28 separate points in a technical pattern, but the central observations do appear to nicely characterize many historical instances. Lindsay called points 8-10 a “separating decline” that distinguishes the series of consolidating peaks from first vertical portion of the speculative blowoff (the “wall of the first story”). Following a choppy correction, the pattern completes with the “domed house” – which is roughly the analog of a narrow head-and-shoulders pattern: “after peaking at 25, price tumbles to 26, retraces to 27, before heading lower to 28, completing the pattern.”
Though the “separating decline” after the mid-1999 consolidation was quite deep, as was the initial decline from the January 2000 peak in the Dow Industrials, the same essential features were evident then as well. The correspondence isn’t nearly as pretty as in the present instance, or those of 1973 or 1929. It’s worth keeping in mind that despite a hard initial decline, many (though not all) historical bull market peaks include an “exhaustion rally” anywhere between 2-9 months after the market peak, which can carry prices within a few percent of the high. The problem is that there is too much variability to count on either their timing or extent.
From the standpoint of investor psychology, it seems understandable that the speculative enthusiasm and short-covering that contributes to bull market tops is fueled when the market “breaks out” after a period of consolidation (and what Lindsay called a “separating decline”). The blowoffs that followed – both recently and in the examples above – were accompanied by clear overvaluation on reliable measures, and also featured clearly defined overbought conditions and lopsided bullish sentiment.
I’ll say this yet again, because it’s a crucial point – we would have zero interest in historical analogs like this if the recent market peak was not also accompanied by an extreme overvalued, overbought, overbullish, rising-yield syndrome that – prior to the past year – has emerged only at major market peaks. As with the recent log-periodic bubble, the pattern itself should be simply be treated like an interesting experiment. Lindsay’s and Sornette’s observations are largely consistent in that Lindsay’s pattern is basically a slightly irregular refinement of the very end of a Sornette bubble. The “three peaks” of Lindsay’s pattern correspond to log-periodic oscillations, and the left side of the “domed house” is essentially a final blowoff and short squeeze featuring much shallower fluctuations approaching the high.
Without tracing through over a century of price data for every instance (including “setups” that did not follow through), we can’t say categorically that this pattern is always followed by market losses. What one can say is that when Lindsay’s pattern has been accompanied by rich valuations (say, a cyclically adjusted P/E over 18), the market has typically been at the cusp of a significant retreat. Those periods of rich valuations are easily identified, and the corresponding blowoff patterns emerge in 1901-02, 1906, 1929, 1937, 1961, 1966, 1969, 1972-73, 1987, 1998, 2000, and today. The 2007 peak had less fidelity to Lindsay’s pattern because the reflex rally in October slightly exceeded the July peak of that year. Of course, lopsided bullish sentiment – as we observed in December and January – further narrows the set and worsens the average outcome, as do razor-thin risk premiums on corporate debt, soaring margin debt, and severely overbought conditions following a largely-uncorrected multi-year market advance. It’s not any single pattern that concerns us here, but rather the entire syndrome of classic speculative features that accompanied the recent peak – in the words of Zorba the Greek, “the full catastrophe.”
For the past four years, the stock market has exhibited the classic characteristics of a bubble as defined by a log periodic advance. Fueled by a historic amount of stimulus from the Federal Reserve, the cyclical bull market from 2009 has accelerated into an unsustainable advance and the next long-term top will almost certainly be followed by a violent correction that will result in substantial losses. In early January, we noted that the historic extreme in bullish sentiment suggested that the bubble was on the verge of collapse. Since then, the S&P 500 index has moved sharply lower, indicating that the top of the bubble may be in the process of forming.
However, as we often note, a cyclical top is a process, not an event. The recent breakdown of the power uptrend from 2012 is the first sign of a long-term reversal, but market behavior during the next several weeks will determine if the next cyclical bear market is commencing.
The latest intermediate-term cycle low (ITCL) is imminent and it could form at any time. How the stock market behaves following the confirmed formation of the latest ITCL will tell us if a long-term top is likely developing.
Regardless of whether the next cyclical top is forming right now, it is critical to maintain focus on the long-term view. The bull market from 2009 is long overdue for termination and market investment risk remains at an extremely high level.
As with all bubbles, it is impossible to predict when the inevitable collapse will occur with a meaningful degree of statistical confidence. However, recent developments suggest that a long-term reversal could be in progress right now, so it will be important to monitor market behavior carefully during the next several weeks. Given the magnitude and duration of the developing stock market bubble, it is a virtual certainty that the next cyclical downtrend will be extremely violent and severe. If this bubble is followed by a typical post-bubble correction, the S&P 500 index will likely lose 30 to 50 percent during the forthcoming bear market. Therefore, now remains a time for extreme caution and we remain fully defensive from an investment perspective.
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Every January, we conduct a comprehensive review of our forecasting and signal performance during the previous year. Accountability is very important to us and this performance review is another way for us to demonstrate our commitment to providing you with a highly reliable service. The audit process itself is admittedly tedious and time-consuming, but we believe it ultimately provides great benefit to both you and us.
In every short-term, intermediate-term and long-term forecast, we provide outlooks based on technical and cycle analysis of the markets that we monitor. Our forecasting methodology identifies two scenarios, one bullish and one bearish, along with the approximate probability of the more likely scenario, providing there is one. These outlooks fall into one of four broad categories.
If both scenarios are equally likely, they each have about a 50% chance of occurring.
If one scenario is slightly more likely, it has about a 60% chance of occurring.
If one scenario is more likely, it has about a 70% chance of occurring.
Finally, a highly likely scenario is at least 80% likely to occur.
The likelihoods associated with these outlooks are intentionally imprecise. We do not believe it is possible to calculate probabilities with a high degree of precision when it comes to financial market forecasting, so each category covers a relatively large range and offers only a rough estimate. However, rough estimates are all you need as an investor or trader to be successful over the long run. A disciplined strategy of aligning yourself with the likely scenarios and protecting yourself from the unlikely ones will invariably produce gains over time. With the odds consistently on your side, you will be successful.
The key, of course, is to have reliable probabilities on which to base your decisions. We may claim that a given scenario is ~70% likely, but what assurance do you have that this assessment is reasonably accurate? The only way to know for sure that our forecasting process is reliable is to review the results of past predictions. We performed this auditing process for every forecast during 2013 and the results are summarized in the following table.
Each column displays the actual performance of a given forecast category during 2013. The top row, labeled “All Markets,” compiles the results for every forecast in every market that we monitor, and then subsequent rows display the results for individual markets. As usual, there was a great deal of variance from market to market, especially in the equally likely category, reflecting underlying long-term trends. If you would like to check the results of the audit yourself, click on the link below the table to download the spreadsheet containing the data.
Our computer models produced 1,817 forecasts during 2013 and our methodology performed very well during the year. The equally likely and ≥80% likely categories were very close to their theoretical values at 45.3% and 84.5%, respectively. The ~60% and ~70% likely categories were well above their theoretical values at 69.5% and 81.8%, respectively. Our computer models are intentionally conservative with their projections, especially when it comes to scenarios that are at least 70% likely, but these results suggest that our models remain a little too conservative for the ~60% and ~70% categories. We will continue to use these audit data to fine-tune our forecasting process moving forward, but an important takeaway from these results is that our computer models continue to perform exceptionally well when it comes to identifying likely scenarios. In other words, when we forecast that a given scenario is ~70% or ≥80% probable, you can be confident that it is at least that likely. We have now evaluated more than 10,000 forecasts and the actual probabilities for all categories since we began auditing our forecasts are displayed in the following table.
Inflection Point Identification Audit
Our cycle analysis (CA) methodology identifies temporal inflection points across all time frames for the markets that we monitor. Once a confirmed cycle low is in place, we use CA to determine the window during which the next low is likely to occur. We have tested our methodology using several decades of historical data and the results of this validation process indicate that approximately 70% of all cycle lows should occur within the predicted window. Of the lows that develop outside of the window, about 20% typically occur before it begins and 10% typically occur after it ends. The following table summarizes the performance of our CA during 2013.
There were 69 cycle lows across all markets and 44 (63.8%) of them occurred in the predicted window, which was slightly lower than theoretical expectations. Of the remaining lows that formed outside of the window, 18 (26.1%) occurred before the window and 7 (10.1%) occurred after it, which was slightly higher than expected for the occurrences before the window. While it is important for actual forecasting results to align closely with theoretical expectations, the ultimate goal of CA is to reliably identify temporal inflection points as they are developing. In this regard, we had another very successful year, as 66 (95.7%) of the 69 lows were correctly identified in real-time as they formed. Even when a given low does not develop within the predicted window, having an accurate time frame for its arrival still enables it to be reliably identified, regardless of whether it is “early” or “late.”
With regard to all inflection points (including alpha highs, alpha lows, beta highs and beta lows), our methodology correctly identified 92.6% of all turning points, while issuing false signals only 4.3% of the time.
The following series of charts displays the identified turning points for each market, along with the accompanying false signals.
US Dollar Index Intermediate-term Inflection Points
Gold Market Intermediate-term Inflection Points
Oil Market Intermediate-term Inflection Points
Overall, our inflection point identification process performed exceptionally well once again in 2013 and we do not foresee making any meaningful changes to the methodology.
Our forecasting based upon technical and cycle analysis provided highly reliable outlooks throughout the year. Our inflection point identification process had a very successful year as well, correctly identifying developing lows in real-time 95.7% of the time and identifying 92.6% of all inflection points while issuing false signals only 4.3% of the time.
Overall, it was another violent, volatile year in the markets that we monitor, which is precisely what we anticipated during this stage of the secular bear market in stocks that began in 2000. The current cyclical bull market in stocks that began in early 2009 is displaying typical characteristics of a late-stage bubble and it will almost certainly terminate sometime during the first half of 2014, so it will be important to monitor market behavior closely for the development of the overdue cyclical top. The secular bear is still several years away from its terminal phase, so we expect the current environment of volatility and violent price behavior to persist during the coming year.
At a current duration of 58 months, the cyclical bull market in stocks that began in early 2009 is long overdue for termination and the character of market behavior during the last 12 months suggests that we are in the final, speculative blow-off phase of the rally.
Additionally, since early last year, stock market investment risk has remained in the highest one percentile of all historical observations. The latest speculative advance from October has increased risk to another historic extreme, joining a select group of four time periods that includes the long-term tops in 1929, 2000 and 2007.
According to the valuation components of the data used to calculate investment risk, the S&P 500 index is priced to produce an annual return of only 2.0 percent during the coming decade. Therefore, when you take into account the current dividend yield on the index, these highly reliable data suggest that stocks are poised to gain nothing in real terms during the next ten years. Granted, the market will likely go nowhere in an interesting fashion, but buy-and-hold investors who are entering the stock market at this level will almost certainly experience extremely poor performance during the next decade. Fueled by a historic amount of stimulus from the Federal Reserve, the cyclical bull market in stocks that began in 2009 continues to exhibit the characteristics of a classic bubble as defined by a log periodic advance.
As with all bubbles, it is impossible to predict when the inevitable collapse will occur with a meaningful degree of statistical confidence. However, extremely bullish investor sentiment during the last several weeks has caused our sentiment score to decline to the -100 level for the first time since early 1987. In October of that year, the stock market experienced one of the most memorable crashes of the past century. This extremely bearish reading suggests that the current bubble is on the verge of collapse.
Given the magnitude and duration of the developing stock market bubble, it is a virtual certainty that the next cyclical downtrend will be extremely violent and severe. If this bubble is followed by a typical post-bubble correction, the S&P 500 index will likely lose 30 to 50 percent during the forthcoming bear market. Of course, there will come a time when the risk/reward profile of stocks is once again favorable and the judicious study of market data will signal when that next long opportunity develops, just as it did in March 2009. However, now is a time for extreme caution and we remain fully defensive from an investment perspective.
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