Will History Rhyme?

Executive Summary

In this week’s Market Update, I share comments made by economists Dr. John Hussman and Jeremy Grantham as well as quotes from Benjamin Graham and David Dodd published after the 1929-1932 stock market crash. The first graph below from Dr. Hussman’s most recent Market Comment shows stock market overvaluation above all historical observations, while the second graph valuation methodology suggests a 12-year forward average return for the S&P 500 of -6% annually. Dr. Hussman goes on to reference Jeremy Grantham’s study of market bubbles across history and how they all end in exuberance. And then finally Dr. Hussman shares a quote from Graham and Dodd regarding the speculative period from 1921-1933, when the “new era” doctrine implied “good stocks” were “good investments” regardless of price. The current speculation and fear of missing out may sure rhyme with the “new era.”

Please proceed to read The Details below for more information.

“Those who cannot remember the past are condemned to repeat it.”
–George Santayana

The Details

Economist Dr. John Hussman writes a monthly Market Comment in which he shares detailed research on the state of the stock market. The essence of his research involves studying historical data, patterns, cycles, etc. Closely examining historical outcomes can help in preparing for what the future might bring. As Mark Twain said, “History doesn’t repeat itself, but it often rhymes.” 

Since Dr. Hussman wrote in June, “Based on the present combination of extreme valuations, unfavorable and deteriorating market internals, and a rare preponderance of warning syndromes in weekly and now daily data, my impression is that the speculative market advance since 2009 ended last week.” Of course, this was followed by an admission that the market could advance higher, but any further moves would be minimal. The market advanced slightly before retreating in mid-July. Since the July peak, the market has bounced back up approximately 1% higher than the mid-July high. The fear-of-missing out speculators are still in action.

Market valuation, as seen in the graph below from Dr. Hussman’s most recent Market Comment, shows a level of overvaluation above all historical observations. (To read the full Market Comment, click here.)

The following scatter plot shows all datapoints of the valuation methodology Market Capitalization divided by Gross Value-added (including estimated foreign revenues), similar in theory to Price-to-Revenue, from 1928 to present. In addition to the valuation level shown on the horizontal axis, the subsequent actual 12-year return for the S&P 500 based upon each level of valuation, is shown on the vertical axis.

The graph above indicates the current valuation result suggests a 12-year forward average return for the S&P 500 of -6% annually.

Dr. Hussman stated in his recent Market Comment, “In mid-July, we saw the largest preponderance of overextended warning syndromes since the March 2000 and January 2022 market peak. At present, the S&P 500 is less than 1% above its July peak, yet there’s a far more palpable tenor of fear, capitulation, and defeat surrounding the very idea of a defensive market outlook. The exuberance is contagious, as are narratives of soft landings and a fresh ‘rate cutting cycle.’

Still, it’s useful to remember how this ends. Jeremy Grantham’s work, like ours, is informed by the study of countless bubbles across history. They always end in exuberance: ‘Everyone feels great, and that’s how you get to a market peak. You feel great about everything. Of course, almost by definition. When do you start going down? You still feel great. You just don’t feel quite as great as you felt the day before. […]

What will matter from here is full-cycle discipline, flexibility, and mindfulness of market conditions as they change. Unfortunately, those are the last things investors have on their minds. Instead, investors have become convinced that it is enough to buy and hold stocks with no thought about price, valuation, or the relationship between market conditions and market outcomes. Investors seem to imagine that expected returns will simply mirror average historical returns, completely ignoring the valuations that were responsible for those historical averages.

Given where we stand in the market cycle, if I were to include nothing in these monthly comments but the quote below from Graham & Dodd, published after the 1929-1932 collapse, I would be content that I had done investors a service.”

“One of the striking features of the past five years has been the domination of the financial scene by purely psychological elements. In previous bull markets the rise in stock prices remained in fairly close relationship with the improvement in business during the greater part of the cycle; it was only in its invariably short-lived culminating phase that quotations were forced to disproportionate heights by the unbridled optimism of the speculative contingent.

But in the 1921-1933 cycle this ‘culminating phase’ lasted for years instead of months, and it drew its support not from a group of speculators but from the entire financial community. The ‘new era’ doctrine – that ‘good’ stocks were sound investments regardless of how high the price paid for them – was at bottom only a means of rationalizing under the title of ‘investment’ the well-nigh universal capitulation to the gambling fever.

Why did the investing public turn its attention from dividends, from asset values, and from average earnings to transfer it almost exclusively to the earnings trend, i.e. to the changes in earnings expected in the future? The answer was, first, that the records of the past were proving an undependable guide to investment; and, second, that the rewards offered by the future had become irresistibly alluring.

Along with this idea as to what constituted the basis for common-stock selection emerged a companion theory that common stocks represented the most profitable and therefore the most desirable media for long-term investment. This gospel was based on a certain amount of research, showing that diversified lists of common stocks had regularly increased in value over stated intervals of time for many years past.

These statements sound innocent and plausible. Yet they concealed two theoretical weaknesses that could and did result in untold mischief. The first of these defects was that they abolished the fundamental distinctions between investment and speculation. The second was that they ignored the price of a stock in determining whether or not it was a desirable purchase.

The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. Yet the new-era theory led directly to this thesis… An alluring corollary of this principle was that making money in the stock market was now the easiest thing in the world. It was only necessary to buy ‘good’ stocks, regardless of price, and then to let nature take her upward course. The results of such a doctrine could not fail to be tragic.

That enormous profits should have turned into still more colossal losses, that new theories should have been developed and later discredited, that unlimited optimism should have been succeeded by the deepest despair are all in strict accord with age-old tradition.”

– Benjamin Graham & David L. Dodd, Security Analysis, 1934

When this extended speculative cycle eventually ends, I believe we will find that history does rhyme with the likes of post-1929 and/or post-2000.

The S&P 500 Index closed at 5,738, up 0.6% for the week. The yield on the 10-year Treasury Note rose to 3.75%. Oil prices decreased to $68 per barrel, and the national average price of gasoline according to AAA rose to $3.22 per gallon.