The second you start to feel comfortable as an investor should be precisely the moment you start to question everything.
The problem is, part of being too relaxed is letting your guard down and becoming blind to swelling market pressures.
That’s the crux of the latest bearish argument from John Hussman, the former economics professor who’s now president of the Hussman Investment Trust. Having made a name for himself by repeatedly predicting a stock market decline exceeding 60% and forecasting a full decade of negative equity returns, Hussman says most investors are blissfully and unwillingly ignoring mounting headwinds.
“The key point is that strong investment opportunities are almost always born out of discomfort,” Hussman wrote in a recent blog post. “Likewise, market collapses are almost always born out of confidence and euphoria.”
Hussman says traders who feel too comfortable with market conditions are more likely to commit the expensive mistake of adding to stock positions at lofty valuations. Those same investors then only sell when their confidence has evaporated, usually after a period of weakness that sees them exiting positions at a loss. It should be exactly the opposite, according to Hussman.
He provides the visual representation below to help explain his preferred strategy. His main point is that if a trader holds stocks from a green patch (an uncomfortable environment) and then exits when it flips back to red (a comfortable environment), it’s a strategy that “easily dominates” its inverse.
To make matters even more ominous, Hussman says the degree of investor negligence has been stretched to historical levels, which means the resulting fallout will be outsized relative to normal history.
“The duration of this episode of euphoria has been stretched to an extent that will make the depth of subsequent losses far worse than in most prior market cycles,” he said. “Over the complete market cycle, that constant desire for comfort is extremely costly.”
So what are the specific fundamental issues facing the equity market? If you’ve followed any of Hussman’s writing in the past, you likely know that valuations are a main point of consternation. But this time around, he’s chosen to focus on the psychological element he thinks is exacerbating the problem.
Traders are ignoring market conditions that are “easily among the most hostile in history” and offering meager risk premiums, says Hussman. He attributes this to the investment community at large being too backward-looking, which distracts them from the catastrophe brewing right in front of them.
Add those weak payouts to increasing investor anxiety and rising rates that are making stocks less appealing by comparison and you have a recipe for disaster, he says.
“A market crash is nothing more than a period where low risk premiums are pushed abruptly higher,” Hussman wrote. “For that reason, the combination of thin risk premiums, increasing risk-aversion, and upward yield pressures is the single most negative set of conditions an investor can face. Ignore this paragraph to your detriment.”
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