It makes John Hussman sick when people praise the Federal Reserve.

Yes, the central bank’s historically easy monetary policy helped drag the US out of its worst economic collapse in almost a century. But Hussman argues that this approach was ultimately “deranged,” and has created a bubble that’s threatening to put the 2008 financial meltdown to shame.

To Hussman — a former economics professor who’s now the president of the Hussman Investment Trust— the Fed hasn’t earned the plaudits it often receives. He argues the market has yet to feel the complete aftermath of the bank’s unprecedented stimulus.

“The current back-slapping about the success of extraordinary monetary policy is a lot like declaring victory in a football game at halftime, just before a flock of fire-breathing dragons swoops onto the field and eats the leading team,” he wrote in a recent blog post. “We have to allow for the possibility that the second half of the game will be violently unrecognizable.”

Hussman estimates that the coming crash will wipe out more than $20 trillion in market value over the next few years. And he blames the Fed.

“The Fed created yet another yield-seeking bubble that has encouraged vastly expanded indebtedness in every sector of the economy,” he explained.

A nuanced look at the role of valuations

However, there’s an obvious elephant in the room when it comes to Hussman’s commentary: He’s been calling for the equity market to lose two-thirds of its value for months, and it hasn’t happened yet. In fact, stocks have chugged higher, setting new records seemingly every other week.

Hussman is well aware of this fact, and has honed his bearish forecast over the past several months. To him, it’s no longer enough to point out the historically-extended stock valuations underpinned by Fed accommodation, even though they remind him of the periods around the 2000 and 2007 market peaks.

It’s more nuanced than that. Hussman is now focused on the so-called market internals accompanying those lofty valuations — otherwise known as the daily gyrations occurring beneath the surface of major indexes.

Hussman argues that those internals can provide a good reading of short-term investor psychology, and can signal whether traders are in a speculative or risk-averse mood.

When speculation starts to wane, that’s when the market is most vulnerable to a sharp downturn. And when that’s coupled with stretched valuations, it’s a toxic situation all around.

In recent months, Hussman notes that the S&P 500‘s ascent to new highs has been driven by an increasingly narrow group of stocks. This is the type of weak internal development that worries him.

The chart below sees this dynamic in action. It shows every instance in the past 25 years that (1) the S&P 500 has been within 0.6% of a five-year high, (2) the number of NYSE stocks at 52-week lows exceeded 4% of issues traded, and (3) that last figure was at least 50% above new highs.

“The only time we’ve ever seen a confluence of risk factors anywhere close to those of today was the week of March 24, 2000, which marked the peak of the technology bubble,” Hussman said.

Hussman Funds

“The profound narrowing we observe in daily data, coupled with repeated leadership reversals within a fraction of a percent of the recent market highs, is what amplifies the likelihood that recent valuation extremes will have immediate and severe consequences,” Hussman added.

He continued: “We observed a similar combination of internal divergences, leadership reversal, and ragged participation immediately surrounding the 2007, 2000, 1987 and 1973 market peaks.”

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 its seemingly unstoppable grind higher, he’s persisted with his calls, undeterred.

But before you dismiss Hussman as a wonky perma-bear, 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 between 2007 and 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 current 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.

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