By John P. Hussman, Ph.D.
Last week, we observed a significant deterioration of market internals. On the slightly brighter side, from a valuation perspective, the pullback in the market has modestly increased our estimate of likely 10-year S&P 500 total returns from about 3.4% at the market's peak to about 3.9% presently. That's an improvement, but the muted extent of that improvement should provide some indication of the extent of market losses that would be required to restore meaningfully attractive prospective returns.
From the standpoint of market action, we presently see two lines of critical support. The first is right here at current levels. A week ago, I noted that "one or two more reasonably sloppy weeks would significantly damage market internals." Last week's market action was more than sloppy, with the result that even another modest down week would signal a measurable shift of investors toward risk aversion – and if history demonstrates one thing, the worst periods for the market are those where risk premiums are thin and risk aversion is increasing. A second line of support corresponds to the March lows, where a deterioration would throw a great number of technical trend-following methods simultaneously into sell mode. Whatever one thinks of those methods, investors should probably not ignore the prospect of a speculative liquidation in a market too overvalued for fundamentalists to be interested.
My guess (which we don't trade on and neither should you) is that after several weeks of declines, the market has a good chance of stabilizing and possibly advancing from the present line of support, as investors try to "buy the dip" despite weakening economic data, divergent market internals, and limited prospects for further government stimulus. This is also the general picture for various ensembles of market conditions we examine – relatively neutral short-term (improved from quite negative a few weeks ago), but still with a negative average return/risk profile looking out more than a few weeks. For our part, our overall range of flexibility remains between a tight hedge and about 10-20% exposure to market fluctuations, with a strong line of downside protection still essential in any event. Again, this is because a break of various nearby support levels here would likely prompt an exodus by a large trend-following contingent of speculators, in an environment where value-conscious investors would not have much interest except at substantially discounted valuations.