- Stock valuations are at historic highs by many measures as the Fed begins to tighten policy.
- Many investors believe the central bank will soon step in and ease policy.
- According to John Hussman, the Fed will not be able to stop a crash once sentiment has turned.
Part of the reason stocks have surged to such historic levels over the past two years has been investor belief in the “Fed put”: the idea that the Federal Reserve would step in to provide further accommodation if stocks dropped any significant amount.
It’s made investors insatiably bullish because the idea has largely been legitimate. In the 18 months or so following the start of the pandemic, the Fed repeatedly assured investors that it was fully committed to providing its entire arsenal of support – ultra-low interest rates, quantitative easing, and persistent long-term forward guidance that these policies would continue – until the economy was back on track.
But now things have gotten sticky, as the Fed’s uber-dovish policies have helped fuel 40-year-high inflation. It is now pulling its support faster than it had planned, and is expected to hike interest rates several times this year.
Yet, the idea of the “Fed put” still lives on in the minds of at least some investors. This is partly because the Fed risks causing a
itself if it tightens too quickly. If this happens, it’ll likely back off of its hawkish tilt, and revert easier conditions for a time.
Bank of America recently said that about 30% of the fund managers they surveyed believe stocks have to be down another 16% for the Fed to step in again.
But even if that’s the case, the central bank’s easing will not be able to stop a mammoth stock market crash. That’s according to John Hussman, the president of the Hussman Investment Trust who called the 2000 and 2008 market crashes.
According to Hussman, investors mistake the Fed’s relationship with stocks as “mechanical” – meaning they believe that the Fed’s asset purchases and low interest rates somehow prop up stocks in a definitive, real way.
Instead, Hussman said in a recent commentary that the real impact of dovish Fed policy is on investor psychology. And once sentiment turns sour, the Fed can do little to quickly turn things around.
He cited the 2000 and 2008 crashes, when stocks fell around 50%, as examples of times when the Fed was easing policy yet stocks still suffered major downturns.
He also cited the market’s returns when its internals – which includes valuations – were unfavorable and the Fed was easing, versus other environments.
“Fed easing has not reliably supported stocks during periods when investor psychology has shifted toward risk aversion,” Hussman said. “That’s a distinction that many investors are likely to overlook, with devastating consequences, as this Fed-induced yield seeking bubble collapses.”
Today, stocks are at even higher levels of risk than they were before those two crashes, Hussman said, because of how much the Fed stimulus has pumped up valuations.
Here’s where things stand in terms of the S&P 500’s average margin-adjusted price-to-earnings ratio.
And here’s the so-called Warren Buffett indicator, which is the ratio of total US stock market capitalization to US GDP. Buffett calls it “probably the best single measure of where valuations stand at any given moment.”
“The ratio of US
/ GDP began 2022 at a record extreme of 2.82, compared with a multiple of 1.88 at the 2000 bubble peak, and a historical norm of just 0.78. When you look at market capitalization, recognize that as much as 72% of it may be air. That is the hazard. “
Hussman said a crash to the magnitude of 72% may not necessarily happen – though it could. But in general, investors should expect poor returns over the next decade from the S&P 500.
Hussman’s track record – and his views in context
Hussman is certainly not alone in his belief that valuations will hinder future returns.
Savita Subramanian, head of US equity and quantitative strategy at Bank of America, has said in recent months that she expects the S&P 500 to deliver negative returns over the next decade, not including dividends. More near-term, Morgan Stanley’s Chief US Equity Strategist Mike Wilson believes stocks still have around another 10% to fall.
Desmond Lachman, a senior fellow at the American Enterprise Institute and a former deputy director at the International Monetary Fund, also told Insider this week that he sees a bubble in US equities and real estate.
Others, meanwhile, reject the idea that valuation plays any significant role in near-term future performance. The CIO of Goldman Sachs’ Investing Strategy Group, Sharmin Mossavar-Rahmani, recently rattled off a number of reasons valuations should not hurt the market in 2022.
It’s an uncertain time. Inflation could cool off sooner than expected, prompting the Fed to back off from tightening so quickly. It also might not. No one, not even top economists and the
seems to know where it’s going.
Right now, Wall Street remains generally constructive, with the average 2022 S&P 500 price target among top strategists at a bullish 5,000 (the index closed on Friday at 4,348). However, many of these targets are continuously moving as investor expectations shift on what Fed policy will be.
For the uninitiated, Hussman has repeatedly made headlines by predicting a stock-market decline exceeding 60% and forecasting a full decade of negative equity returns. And as the stock market has continued to grind mostly higher, he’s persisted with his doomsday calls.
But before you dismiss Hussman as a wonky perma-bear, consider again his track record. Here are the arguments he’s laid out:
- He predicted in March 2000 that tech stocks would plunge 83%, then the tech-heavy Nasdaq 100 index lost an “improbably precise” 83% during a period from 2000 to 2002.
- Predicted in 2000 that the S&P 500 would likely see negative total returns over the following decade, which it did.
- Predicted in April 2007 that the S&P 500 could lose 40%, then it lost 55% in the subsequent collapse from 2007 to 2009.
However, Hussman’s recent returns have been less-than-stellar. His Strategic Growth Fund is down about 45% since December 2010, though it’s risen 2.4% in the last 12 months. Still, the S&P 500 has returned more than 11.3% over the past year.
The amount of bearish evidence being unearthed by Hussman continues to mount. Sure, there may still be returns to be realized in this market cycle, but at what point does the mounting risk of a crash become too unbearable?
That’s a question investors will have to answer themselves – and one that Hussman will clearly keep exploring in the interim.