John Hussman: Post Crash Bubbles

Excerpt from the Hussman Funds' Weekly Market Comment (5/11/09):

It would be very convenient if it was possible to buy the fear lows, participate in the bear market rallies, sell at the peaks, and repeat. Unfortunately, “fear” lows are only evident in hindsight, because as we saw in 2008, a deeply oversold market can become spectacularly more oversold before recovering, and the “fast, furious” spikes off of those lows are often followed by steep failures. Fear lows are only easy to identify in hindsight.

Even if we have observed the ultimate lows of this downturn (which I would not take as given), it does not follow that the decline we've observed over the past 18 months will be progressively recovered without a great deal of intervening difficulty. The S&P 500 has retraced just over 25% of its bear market loss. The 904 level on the S&P 500 was a 25% retracement, and 977 would be a 1/3 retracement, which is not unreasonable. Aside from such retracements, the idea of a “V-shaped” recovery in the market is strongly odds with “post-crash” market behavior, which generally features a long and drawn-out flat period for years afterward. Given the enormous overhang of Alt-A and option-ARM resets scheduled to begin later this year, extending into 2012, such a profile would not be surprising in the present case.

To put the current downturn into similar context, the chart below overlays several historical crashes, with the time scale measured in months. The downturns include the Great Depression (purple), the Japanese Nikkei index which peaked in 1989 (blue), the gold market which peaked in 1980 (green), and the S&P 500 which peaked in 2007 (red). Thanks to Bill Hester for preparing this overlay.

Note that during all of these downturns, the markets did experience very powerful intervening advances as well (indeed, the rally off of the initial 1929 market crash approached 50% before failing). In each case, however, the fundamentals of the preceding bubble had been broken and it took years for the markets and economy to adjust. In the case of gold, the shift in fundamentals was the end of double-digit inflation. In the other instances, including the present one, the shift was from a steeply leveraged economy to a deleveraging one.

To a great extent, the optimism of investors is based primarily on economic “flow” data (spending, job losses, confidence measures) that remain poor, but have been “less bad” than expected. What concerns me far more, however, is that there is a second and almost equivalent mountain of mortgage resets and probable defaults that will begin later this year and extend into 2012. While our unelected bureaucrats have spent over a trillion dollars to make reckless lenders whole, they have done nothing to materially ease foreclosures or avert the oncoming second wave.