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- Investors are gearing up for an interest rate cut that the Federal Reserve appears willing to deliver.
- The prospect of further monetary easing pushed major US indices to their best week of 2019.
- John Hussman — the outspoken investor and former professor who’s been predicting a stock collapse — explains why traders are placing too much faith in the presumed rate cut.
- He also breaks down why the Fed will be powerless to stop a sudden stock crash, even if it’s willing to lower interest rates even further.
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As investors talk themselves — and possibly the Federal Reserve— into another rate cut, there’s a sense among stock-market bulls that more prosperous times are ahead.
That could mean fresh records in major indices. After all, when Fed Chair Jerome Powell hinted last week that further monetary easing could be a possibility, stocks ripped higher. They wound up turning in their best week of 2019 so far.
Noted market bear John Hussman, the former economics professor who is now president of the Hussman Investment Trust, isn’t here to dispel that notion. He does, however, think that further Fed-emboldened risk-taking would be a massive mistake for both investors and the market at large.
His argument boils down to one crucial misunderstanding he says is giving traders false hope: the idea that lower interest rates justify higher stock valuations.
Hussman admits this is true during periods when cash flow is either stationary or growing. But he also adamantly points out that this is not one of those times. In his mind, abiding by the idea that rate cuts will save the market is a mistake.
“The problem is that if interest rates are low because growth is also low, lower interest rates don’t justify any increase in valuation multiples at all,” Hussman wrote in a recent blog post.
He continued: “While Wall Street mechanically recites the aphorism that ‘lower interest rates justify higher valuation multiples,’ that proposition actually holdsonly if the trajectory of future cash flows is held constant.”
Hussman takes it a step further and lays out a completely plausible — and frightening — scenario. He says that if inflation remains around 2%, corporate revenue growth will be just 3.5%. Then, if there isn’t “persistent expansion” in margins, profit expansion will also peak at roughly 3.5% annually.
“Even the mildest retreat in valuation multiples will then likely produce a multi-year period of negative S&P 500 total returns,” he said. “All of this is just basic arithmetic.”
This all feeds into Hussman’s long-standing assertion that US stocks could suffer a crash along the lines of a 60% to 65% plunge. He’s also predicted S&P 500 total returns averaging roughly zero over the next 12 years.
Still, one question remains: What happens if and when the Fed actually does cut rates, since it appears they could as soon as June?
Hussman says it depends on the risk appetite of the market. Sure, investors are feeling invigorated right now, but once they flip the switch into worry mode, he says things could fall apart quickly. That’s right, even the precious Fed won’t be able to save the market.
“When investors are inclined toward risk-aversion, safe low-interest liquidity is a preferred asset rather than an inferior one,” Hussman said. “So creating more of the stuff does nothing to encourage more speculation.”
He continued: “When one recalls that the Federal Reserve eased persistently and aggressively throughout the 2000-2002 and 2007-2009 collapses, it should be clear that a recessionary collapse in stocks would not be interrupted by a sudden shift toward rate cuts, aside for very short-lived knee-jerk reactions.”
Hussman’s track record
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 calls, undeterred.
But before you dismiss Hussman as a wonky permabear, consider his track record, which he breaks down in his latest blog post. Here are the arguments he lays out:
- 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
In the end, the more evidence Hussman unearths around the stock market’s unsustainable conditions, the more worried investors should get. 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 it’s one Hussman will clearly keep exploring in the interim.