Overvalued, Overbought, Overbullish

John Hussman puts the smackdown on the "Stocks are cheap here" thesis so popular amongst certain types of analysts:

"Overvalued, overbought, and overbullish conditions have generally
resulted in disappointing market returns, regardless of other features
of market action. Yet the past several weeks have quietly added a new
ingredient: Treasury bill yields are now higher than they were 6 months
ago, and Treasury yields of all maturities have popped higher in recent
weeks. While this might seem like a trivial and low-magnitude event, it
actually contributes to a syndrome that has invariably been negative
for near-term market outcomes (not to mention the negative long-term
results that overvalued market conditions have historically produced).

As of last week, the Market Climate for stocks was characterized by unfavorable valuations, moderately favorable market action, and a combination of overvalued, overbought, overbullish conditions that has historically been associated with short-term returns below Treasury bill yields. As noted above, even the modest upward pressure on Treasury yields in recent weeks has made the present risks far more pointed…"

Of course, the key is how we define these measures — that will certainly determine how often these elements all line up. Hussman defines them as follows:

Overvalued: S&P 500 price/peak earnings greater than 18
Overbought: S&P 500 at a 4-year high, and at least 5% higher than its level 6 months earlier
Overbullish: Investors Intelligence percentage of bullish advisors above 53%
Yield pressure:  3-month Treasury yield higher than its level of 6 months earlier

None of those metrics are particularly extreme — its the concurrent combination that presents an increasing risk factor.

Surprsingly, prior to the most recent example (November 17, 2006, December 8, 2006 and January 12, 2007), there have only been 8 previous periods when these elements all lined up together:

April 30, 1965
December 18, 1972 / January 5, 1973
August 14/21 1987
April 3, 1998
April 23, 1999
July 2/16, 1999
December 23/31 1999
March 24, 2000

Here’s what they look like on a long term chart:

Overvalued, Overbought, OverbullishWmc070115a

Chart courtesy of Hussman Funds

The market performance subsequent to this signal are detailed at Hussman’s site.


Hazardous Ovoboby!
John P. Hussman, Ph.D.
January 15, 2007

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What's been said:

Discussions found on the web:
  1. david foster commented on Jan 20

    What does the “peak” in “F500 Price/Peak Earnings” refer to?

  2. Leisa commented on Jan 20

    I’m not sure why I always find listening to Marc Faber fascinating, but J. Puplova interviews him on today’s broadcast at financialsenseonline. It may be worth some of your reader’s time.

  3. Fenner commented on Jan 20

    in order to use p/e ratio to forecast future returns in the market, hussman weeds out the extremely low p/e’s of recessions during periods of low earnings. According to him we are at the top of the earnings channel right now, we’re at peak, so the p/e of 18 on the S&P is considered very high. He’s been saying this for several years now and therefore missed the bull run of the fall. His theories are very convincing, however, once you’ve fallen behind the s&p by 12 or more percent over a period of several years (he’s beaten the s&p handily in the past), your theories start to seem suspect. He’s a major bear. Watching the nyse ticks every day as I do when I’m trading, I doubt very much that the amount of capital coming into the markets is going to suddenly stop or even reverse. But what do I know, I’m just a day trader. I do however have capital tied up in his fund, just in case he’s right.

  4. david foster commented on Jan 20

    fenner..thanks. I found the explanation of “peak earnings” on his site, but it’s not obvious whether the peak is of aggregate S&P 500 earnings, or the sum of the peaks of the individual stock earnings–which would be very different since the peaks occur at different times. I’m guessing it’s the former.

  5. JoeyB commented on Jan 20

    These are his opinions. Opinions are a dime a dozen.

  6. Barry Ritholtz commented on Jan 20

    Actually, these are his analyses — they have some value, from both an informational point of view, as well as from an investable thesis.

    Your comment, on the other hand, was an opinion.
    (and thank you for valuing for us)

  7. Philippe commented on Jan 20

    The market’s tale is known

    The analyst’s tales is (please see here under):

    David Wilson
    Jan. 17 (Bloomberg) — Industry analysts are becoming increasingly cautious on U.S. stocks as the market advances, rather than jumping on the bandwagon as they did during the 1990s Internet bubble.
    Just 46.2 percent of their calls in January have been “buy” ratings or equivalents, according to data compiled by Bloomberg. This percentage is the lowest since the statistics start in 1997 and has fallen for six months in a row.
    “Hold” ratings have become almost as common, accounting for 45.6 percent of recommendations this month. The difference of 0.6 percentage point from the “buy” number is the smallest ever. The other 8.2 percent of the calls were “sells.”

    But not all of them in all places

    On London: The “sell” scarcity in analysts’ recommendations

    By Tony Tassell Financial Times
    Published: January 19 2007 18:48 | Last updated: January 19 2007 18:48
    It still goes against the grain of most stock market analysts to issue “sell” recommendations on a company. When reforms of the broking industry were pushed through by Eliot Spitzer, the then New York Attorney-General, in the wake of the bursting of the dotcom bubble, a new world of independent and critical analysis was supposed to have emerged.
    There has been a shift, but one curious anomaly has persisted – the dearth of sell recommendations.

    The title of this article could be the same for France where surprisingly mostly foreign brokers are issuing buy recommendation UBS Lehman Goldman CS are very generous.

    And the strategists say

    « Strategists at 13 other firms tracked by Bloomberg all expect higher prices as well. Forecasts range from 1440 for JPMorgan Chase & Co.’s Abhijit Chakrabortti to 1630 for Prudential Equity Group LLC’s Ed Keon. »

    Assuming that the whole is the sum of the parts:

    One may wonder how the strategists of Wall Street can depart individually from their documented knowledge, the analysts?

    One may wonder how they could be so inspired to singly revise upwards the aggregate opinion of their supports ?

    Inspiring world of logic, in 2003/2004 acquisitions, mergers were not a crowded field PE’s were low, interest rates lower All these acquisitions today are made at two to three times higher prices.

  8. Michael C. commented on Jan 20

    JoeyB said These are his opinions. Opinions are a dime a dozen.

    Yes. And you yourself wouldn’t be on this blog if you didn’t want to hear other people’s opinions.

  9. lurker commented on Jan 20

    I feel like I am seeing double—double tops, or more correctly, POTENTIAL double tops, all over my charts these days. Two prime examples are MA and GOOG. Anyone one else noticing the same thing? Can’t be good as even the academics think there is validity to the double top formation. They may be backtesting for all I know so Seller Beware as MA and GOOG have been great stocks to hold up to now. All I know is they look toppy to me and risk reward would seem poor until they break to new highs. All opinions have value if they make you reexamine and test your own. Just remember that you and you alone are responsible for your investment results so don’t blame the market or someone else’s opinion…I am still raising cash and feeling more and more comfortable with that position. Cheers.

  10. Eclectic commented on Jan 20

    Okay BR, and you too Kathryn. Don’t be a-messin’ with my posting here!

    I feel strongly about the subject and wanted to put it in at least a vaguely related topic but not specifically associated with a topic about “Option Backdating.” The reason is that heaven knows we’ve had plenty of opportunity to witness public discourse about the subject. However, I specifically intended to avoid having my writing here being interpreted as directed at any particular company or its executives, because it isn’t. There are plenty of examples around today of option backdating policies gone bad, and this is not about any one of them in particular.

    Later, if there’s any interest that develops, I’ll more specifically relate this writing to the topic at hand: “Overvalued, Overbought and Overbullish.” Doing so is like putting a hand in a glove after the thesis I’ll present is accepted. But, if it does not fit, you’ll all acquit me of any obligation to ponder on.

    So, here’s my beef… and I hope Herb Greenberg is paying attention and would agree with this analysis… and maybe that wacky and erudite wordsmith, that “Abel” son-of-a-Barron, Al himself, known to often peruse the Big Pic in lieu of hours lovingly spent ravenously caressing page after page of the latest version of Roget’s Thesaurus, might even enjoy this connect-the-dot, albeit non-Shakespearean, logical trek.

    On Backdating Option Grant Prices:

    Let’s take a look at this issue on the basis of simple business law, the kind of law covered in entry-level business law courses even taught in high school. I raise the subject of high school for another reason as well; the average intelligent 10th grader would have no problem understanding that, at minimum, backdated option pricing grants are unenforceable.

    I am neither an attorney nor a paralegal, but listen to my logic in this piece and see if you agree.

    What is a contract?

    A contract really has just a few key points that must be evidenced to make it enforceable. A contract is a promise to do something or provide something, either immediately or over a prescribed time, that the law will enforce. Basic tenants of a legal contract are that: 1) an “offer” is made and; 2) an “acceptance” is given; 3) there must be an exchange of values, or “consideration,” between parties or at least the theoretical realization of a gain of value by one or more party or an incurred detriment of value in the same manner; 4) the “express terms” of the contract must be duly noted, whether in writing as is the usual custom or, in some but not all contracts, verbal understandings can be used and are as valid as written ones when the elements listed above are properly included and provable in a court of law.

    It’s useful to observe that although we typically think of an exchange of money being involved in a contract, it’s possible that even very complex contracts might never involve a monetary exchange. Merely the potential that exists for the realization of a gain or a detriment (in either monetary or non-monetary terms) may be the entire consideration exchanged in the contractual agreement, and the law recognizes this consideration as if it were the only value exchanged. However, bartered values exchanged in a contract are indeed monetary exchanges, just expressed in a different way.

    Without delving deeper into contract law, which would certainly be above my capability and possibly yours unless you’re involved in the law profession, that’s about all that is needed to constitute an enforceable contract.

    Contractual Basis for Employer Granted Stock Options:

    Is a stock option grant an enforceable contract? Of course it is, so let’s look at the individual points that make it an enforceable agreement:

    The offer is made by the shareholders, as represented by the fiduciaries that represent them both in management and on the board of directors, either directly or as recommended by compensation committees populated by board members, and it’s made in good faith. The shareholders make the offer in a manner that can reasonable be couched in this way: “We agree that if an employee executes his management skills in a manner that will contribute to an increased value for our shares, we agree to compensate the employee with an additional value appropriate in some direct manner to the increase in shareholder value.”

    The proof of the acceptance of terms of the offer by the employee who receives option grants is patently obvious in most cases, even if only implied, and I will not pursue it further except to examine the consideration exchanged by both parties at the instant the grant is made.

    Is value indeed exchanged at that moment? Of course it is. The shareholders are immediately burdened with a potential detriment. That detriment is the potential for the likely expression of real monetary value into the immediate dilution of their shareholder equity by the relative amount of the shares granted to the employee. They have made a good faith offer of this future monetary expression at the instant the option is granted, and they stand ready, even obligated by law, to contribute future value to fulfill the obligation. The potential detriment is the consideration offered, and it has real tangible value, and the employee receives it no differently that if he or she had been written a check for funds.

    Too, the employee also contributes his consideration at that exact instant in that he or she obligates themselves with the potential detriment of having to begin, or continue, to duly contribute their good faith management skill and judgment for a given period in an effort to enhance shareholder value, and then failing to receive any more value for the effort than the value received from the shareholders on the date the option is granted. Therefore, both parties give and receive value at the moment the option is granted; that is, they both give and receive consideration, both in current terms, as well as terms expressed in values over time that may or may not alter the initial considerations granted.

    Now we’re getting somewhere, somewhere with teeth that we can put into an objection to the enforceability of backdated employee option grants. How?

    It’s because a backdated option grant that is apparently designed to capture a sharing of the proportional increase in total shareholder value, that is expressed in the difference between the then-current value of the shares and the value of the shares at the back-looking date, constitutes a failure of an exchange of consideration on the part of the employee who benefits from immediate values realized as a result of using the back-looking date. The failure is the same whether the employee understands the nature of the failure or whether the employee is merely represented in the failure by some third party that, at best, has only failed in some manner to understand their fiduciary responsibility to the shareholders.

    The shareholders make the offer in good faith and receive an immediate detriment in return, not only the detriment of a future installment of additional values to the potential exercising of the employee option at share prices higher than the price would’ve been on the correctly dated option granting date, but also the immediate detriment of an instantaneous installment of value to the employee for appreciation in shareholder value that the employee can not possibly earn, because it’s already been realized without requiring the further administration of employee skills that the shareholders are entitled to. The reason is that the values are de-facto at that given instant, as expressed in the already observed share values being determined at that time in current market action.

    Therefore, since the employee can not possibly contribute consideration under the terms of this real or implied contract, one of the absolute minimum required terms of a valid contract is missing; this is not to mention that were the real terms of back-dated option grants explained to shareholders (even if only to their fiduciaries) they may not have constructed the offer to begin with. At any rate, to my mind a backdated option pricing grant contract is void and unenforceable. It may be worse than merely unenforceable, but it is not my purpose here to explore the subject as being any more than a failure to observe the very basics of simple contract law.

  11. lurker commented on Jan 20

    Forgot to mention NYX. Joyride over?

  12. Leisa commented on Jan 20

    Eclectic, you have too much time on your hands! ;>

    “Therefore, since the employee can not possibly contribute consideration under the terms of this real or implied contract, one of the absolute minimum required terms of a valid contract is missing”

    Under the point you argue above, one could argue that consideration by the employee–his/her employment–has already been tendered. It seems like this argument to negate the validity of the contract is rather contorted–like going around one’s a$$ to get to the elbow. (I don’t mean that to sound harsh).

    Many contracts are backdated. So long as the two parties mutually agree, then I do not believe that it negates the contract. However, I’m not attorney nor do I play one on TV, but I have had to write compensation policy and negotiate compensation contracts (among others). (But always handing it over to our corporate counsel for final deification. They loved me because they rarely had to make any changes.)

    I think that the arguable issue is more straightforward. There should be a documented process for the issuance, approval and valuation of stock options process. Most documented processes do not have the provision of “changing dates as necessary to ensure maximum compensation.” Because no process would have that clause, and because no board member should approve any policy that claims such flexibility, then that should provide some insight as to whether or not such flexibility is kosher. I think that all would agree that it is not kosher.

    According, absent a documented process, or one that allows for the “flexibility” offered in many of these cases, I would argue that there is rather severe dereliction of duty and failure to carry out fiduciary responsibilities by the Board. Shareholders have every right to expect that company leadership maintains minimum processes and controls to govern material contracts. In the event that there is evidential matter suggesting otherwise (backdating of options, failure to have written procedures or appropriate oversight or other shenanigans) then the shareholders have a basis for asserting lack of fiduciary responsibility or worse.

  13. Eclectic commented on Jan 20

    Leisa, per you:

    “Under the point you argue above, one could argue that consideration by the employee–his/her employment–has already been tendered.” …end quote

    Very dicey ground there, Sister. How can shareholders possibly benefit from a stock increase that occurs “prior” to the option grant that is offered partially as an incentive for obtaining that very stock price level that already exists?

    Too, Leisa, under your theory Mr. Manager X may rightfully claim an option backdated to ‘zero;’ that is, in theory all the way back to the IPO, or even beyond that and back as a claim against the venture capital that funded the original company.

    No, you’re touching on part of my issues with this practice. It derives from an arrogance regarding the rights of shareholders versus the rights of management… from a sort of devil-may-care attitude that the phantom equity in unrecognized shareholder dilution will always cover the excesses of management.

    I’m sure in writing the protocols you mentioned, that you haven’t been so bold as to recommend procedures for wholescale price point ‘pinning’ of employee option strike prices at prior historic lows.

    I don’t object to the orderly procedures of selecting strikes within a window range of dates that are prescribed by policy beforehand, that is approved by responsible fiduciaries within the company and made public to the shareholders.

    Except that I appear to feel more strongly that these are unenforceable contracts, you really spent several paragraphs agreeing with me. Say no?

  14. Eclectic commented on Jan 20

    Maybe this wasn’t entirely clear:

    “How can shareholders possibly benefit from a stock increase that occurs “prior” to the option grant that is offered partially as an incentive for obtaining that very stock price level that already exists?”

    Maybe this is a better way to say that:

    “How can shareholders possibly benefit from the granting of an employee stock option when the stock price has already increased “prior” to the granting of the option that is offered partially as an incentive for obtaining that very stock price level that already exists?”

  15. Lauriston commented on Jan 20

    Overvalued: this is not an absolute parameter, and we all know how earnings can be fudged and fudged, so I wouldn’t put any stock on PE values, no pun intended. Also, markets could become even more “overvalued” as we have seen in the past

    Overbought: the definition of overbought is tenuous wrt markets, could be even more overbought, no limits presented.

    Overbullish: ditto, could be even more overbullish, why not? what are the limits? 0-100%?

    Yield pressure: historical evidence that yield pressure/curve means anything is laughable. Sample space is way too small, conclusions are ridiculous

    As the Chinese say, “Poverty is the common face of all scholars.”

  16. agent00yak commented on Jan 20

    While I’m bearish on the overall market as well, it seems like Huffman engaged in some form of curve fitting/data mining. I’m not saying he used a computer to curve fit, but he probably eyeballed the numbers from a lot of different sources to make sure he got numbers and times that fit his thesis. The odd thing is that neither Barry not John Maudlin mentioned this possibility and how it might effect the relevance of Hoffman’s data mined findings.

  17. Gary commented on Jan 20

    So many short term views of the market nowdays. Pure and simple human nature never changes. Mankind always and I mean always goes to extremes. Ex: Tulips, East India co., John Law and the Mississippi co., gold in the 80’s, Nikkei in 89, Nasdaq in 2000, real estate in 05, etc, etc, etc. What was the end result of each and every one of these …collapse. No exceptions. The market topped in 2000 from a multi year secular bull market. Even after huge amounts of liquidity pumping by every central bank in the world and tremendous gains in business profitablity what have the markets done? Basically gone nowhere. Sure there are a few emerging markets and countries rich in natural resources that have made gains past their 2000 highs but the vast majority of major markets around the world are still underwater after 7 years. People will forever look for the free lunch, the sure fire get rich quick scheme. We can’t start another secular bull market until all the excesses from the bubble years have been wrung out of the system. Every generation has to be taught the hard way that there is no free lunch. The markets have to make the final run to black pessimism that always signals the end of a secular bear market. Business have to be selling dirt cheap and the public has to get to the point where they never want to see a stock again. The course of human nature has to run to the opposite extreme just like it has every other time in history before the next secular bull can start. This takes time it doesn’t happen for the stock market in 2 years and it certainly hasn’t had time to run the full course in real estate after only 1 1/2 years. I dare say that we haven’t changed since the Tulip mania of the 1600’s, The East India co., The Mississippi co. or the 29 bubble. What would make anyone think that humans are not still motivated by hope and greed today just like they were 400 years ago. When the Dow is selling for P/E ratios close to its dividend and the Dow gold ratio is close to 3-5/1 then I will be ready to say that the secular bear market is over and buy stocks. My guess is that very few will step up to the plate at that time and buy though because they will have believed the wall street hype and will have watched their investments dwindle over the years. For the few that can look beyond the BS and let common sense govern their actions then that is the time that fortunes will be made. BTW who was that again that was buying everything he could get his hands on at the bottom in 74 and is now a multibillionaire? Oh yeah now I remember it was Warren Buffet.

  18. My1ambition commented on Jan 21

    Although I agree with your general sentiment I see two slight faults.

    1. Falling in line with what Lauriston mentioned, how do we know when we are overbought/oversold? There is no real indicator other than extreme sentiment to either side, one of which we don’t properly see in any sector.

    2. This is the Warren-Buffett-mantra contrarian-thinking too-bad-I-Missed-the-rally mindset. I’m not saying it’s wrong but that everyone seems to love it and proclaim it just about until it comes down to actually investing their life savings against the crowd (like Buffett did).

    All said, did you call the market in 29, the 80s, 1989, 2000, 2005?

    Do you have the track record to say that NOW is one of those times?

  19. kaan commented on Jan 21

    The exact timing of the market movements are beyond capabilities of human investors but we can be almost sure within 10 years we will see much lower asset prices.

    The reason is the dynamics of asset bubbles. It requires accelerating credit growth. In other words not credit should expand but also at ever increasing rates.
    At a point this reqirements overwhelms even the most compotent Ponzi schemers in Wall Street and Fed.

  20. Gary commented on Jan 21

    As you might notice I wasn’t trying to say the market was overbought. Overvalued yes. But only to the extent that we haven’t run the full course to black pessimism yet. BTW I didn’t miss the rally. I just got out when the commercial position in the S&P futures became extremely short. If the biggest players are selling I don’t see how the market is going to have much upside. Why risk it? I would rather follow behind them than try and stand on the tracks in front of them and risk getting run over. To all the bulls out there let me ask you, how many of you sold before the correction in May? If you held all the way down then what makes you think you will be able to get out in time when the next bear market starts? I got out because the commercials were telling me that they were selling heavily at that time also. So do I have a track record? No but the largest and smartest participants do, so I just follow behind them.

  21. toon commented on Jan 21

    Arguing with Mr. Market is a total waste of time.
    Trade stocks not markets.
    We are happily shorting BBY, RIMM. GOOG, DELL, AAPL

  22. drsqueeze.com commented on Jan 21

    Hussman’s 3-year performance is 4.79%. Man he’s really crushing . . . the return on my checking account.

  23. Fred commented on Jan 21

    Dr. Hussman is a very bright guy. He is running up against another very bright guy, Keynes, who said, “Markets can remain irrational longer than you can remain solvent.”

  24. Patu commented on Jan 21

    WHats this hussmann guy worthh? 10m, 20m, 30m, or 100m? does anyone know? And just how long has he been bearish? one year?
    6 months? 2 years , six years or one week? Anyone Know? Would it make any difference?

  25. Mark commented on Jan 21

    “WHats this hussmann guy worthh? 10m, 20m, 30m, or 100m? does anyone know?”

    unless he charges a performance fee instead of a set percentage of AUM, what he’s worth is completely irrelevant-

  26. My1ambition commented on Jan 22

    Gary, thanks for your thoughts. Was just playing devil’s advocate in a market I’m just beginning to understand the market I don’t understand. Interesting theory on commercial sellers.

    and drsqueeze.com, just a thought, as I recall the Buffett Partnership return in 1969, just before the turn of the market wasn’t much better at 6.8%. He beat the market though.

  27. drsqueeze.com commented on Jan 22

    Hussman sells option premium. He did well when it was expensive, and now he’s not doing so hot. If he’s betting on the direction of the market, well, then he’s no Warren Buffett.

  28. My1ambition commented on Jan 22

    ah! a Derivative bubble…

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