Stock market is overvalued, overbought and overbullish, according to Hussman

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The following paragraphs come courtesy of John Hussman’s latest weekly newsletter, The rubber hits the road, and are published below with the necessary permission.

“Last week, we observed a subtle shift in yield pressures, which has historically been associated with fairly abrupt ‘air pockets’ in which stocks have typically lost 10% or more within the span of about six weeks. As usual, this isn’t a forecast, but given that we are already defensive on the basis of broader considerations about overvaluation and the overbought status of the market, the pressures we’re seeing on the yield front make our aversion to market risk somewhat more pointed.

“Consider the following conditions: 1) market valuations above their historical norm by any amount at all – for example, a dividend yield on the S&P 500 anything less than 3.7%, and; 2) The 10-year Treasury bond yield and the year-over-year CPI inflation rate higher than their levels of six months earlier (regardless of whether their absolute levels have been high or low).

“If you look at market history since 1940, this condition has been in effect nearly 20% of the time. Yet this set of factors alone has made an enormous difference in the returns achieved by the market. When the above conditions have been in effect at the same time, the S&P 500 has actually lost ground on a price basis, and has delivered an annualized return of just 0.28%. In contrast, when those conditions have not been in effect, the market has advanced at an average annualized rate of 14.94%. Of course, these averages mask a lot of volatility, but it is clear that even the most basic combination of low stock yields and rising yield pressures is hostile to total returns.

“To the above conditions, if Treasury bill yields are also higher than six months earlier (again, regardless of the absolute level of yields), the annualized return drops to -0.83%. Add a discount rate higher than six months earlier, and the annualized return drops to -2.22%.

“Now add overbought conditions (say, a 12-month advance in the S&P 500 of greater than 30%), and the annualized return turns sharply negative, to -39.17%. Overvalued, overbought conditions with rising yield pressures are trouble. Given those conditions, excessive bullishness only worsens the situation. Now, this combination of conditions has never persisted for an entire year, so the actual loss sustained by the market is not so extreme, but suffice it to say that the typical loss has been in excess of 10%.

“Based on the current overbought status of the market, there are only three similar periods that we can identify in post-war data: August-October 1999 (which was followed by an abrupt air pocket of greater than 10%), September-October 1987 (no comment required), and September-December 1955 (which was followed by a 10% correction, a brief recovery, and a secondary decline to re-test the initial low).

“Again, this is not intended as a forecast, but rather to note a historical regularity that seems relevant in a market environment where we are already defensive on the basis of other considerations.”

I have also maintained that US valuation levels are a headwind to stock market performance and will become an even bigger negative once the monetary authorities start removing the “juice”. Although overall market returns may not be exciting off these levels, old-fashioned cherry-picking of individual stocks could still yield good results.

Source: John P Hussman, Hussman Funds, March 8, 2010.

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