Stock market crash: Expert warns S&P 500 will ...

Before a market sell-off, John Hussman's right leg starts tapping unconsciously.

At the moment, he says, it's tapping.

'I thought it might have been the pumpkin pie, but on further analysis, it's because current market conditions are so familiar,' Hussman said in his December market commentary.

To Hussman, there's a clear and simple sequence of events occurring that will eventually drive the market into a downward spiral — a spiral to the tune of a 65-70% drop from current levels.

There's the Federal Reserve's creation of a zero-interest-rate environment, and the corresponding narrative that investors are forced to find returns in riskier assets like equities — or in the 2000s, products like mortgage-backed securities.

Then there's the direct effect this has on equity valuations, which have soared on surging demand for them.

'The notion that 'there is no alternative' but to speculate has again saturated the minds of market participants, driving S&P 500 valuations to levels that are now beyond every historic extreme, including 1929 and 2000, even if we completely exclude economic losses due to the COVID-19 pandemic,' Hussman said.

Hussman, who is president of the Hussman Investment Trust, acknowledges that the Fed employs low rates with the intention of stimulating the economy, but he said they are too ignorant to the more potent impact it has on stock valuations and in turn — at least eventually — investors.

But it's not only the low-rate environment pushing investors into equities that Hussman sees as detrimental to investors. It's also the fact that the Fed too often is there to save the day when the market crashes, only adding to and prolonging the problem.

'The perpetual speculation of Wall Street relies on confidence that every market retreat will be met by another Federal Reserve stick-save,' Hussman said, the emphasis his. 'Yet all of these stick-saves by the Federal Reserve defer a financial collapse only by amplifying its eventual size.'

A no-return world

Hussman illustrated the dire state of valuations with a chart showing margin-adjusted price-to-earnings ratio levels at an all-time high, well above 40.

He said the indicator 'is better correlated with actual subsequent market returns than nearly every alternate measure we've tested or introduced.'

Hussman Funds

Given this extreme territory for valuations, Hussman projects what amounts to a sort of no-return world.

Over the next 12 years, he estimates the S&P 500 will return -3.6%. For portfolios with a 60% allocation to the S&P 500, 30% to Treasury bonds, and 10% Treasury bills, he predicts a -1.7% return.

'Stock prices haven't just priced in a recovery. They're already beyond where they were before the pandemic,' Hussman said.

'Indeed, we currently estimate that the average annual nominal total return of the S&P 500 is likely to lag the returns of Treasury bonds, by fully -4.6% during the coming 12-year period. So much for the notion of an 'equity risk premium.''

To demonstrate why his outlook is so abysmal for the coming decade-plus, and why he thinks a market crash is due, Hussman offered another chart.

It shows the return estimates for Treasury bills, Treasury notes, corporate bonds, utilities, and the S&P 500 for the following 10 years at points right before various market pullbacks: February 2020, March 2009, October 2007, October 2002, March 2000, and August 1982.

Alongside these pre-drop peaks are the current estimates for the next 10 years. All of the above assets are currently at or near the bottom of prospective returns relative to those dates.

Hussman Funds

That said, Hussman is advocating that investors up their allocation to cash and wait for a better buying opportunity.

That buying opportunity will come in the form of a pullback of 65-70%, he said.

He again backed up his view with a chart placing atop of each other valuation levels and S&P 500 sell-offs.

'You'll notice that extreme valuations aren't always immediately associated with drawdowns. That's why you see those white spaces between the blue valuation lines and the red drawdown areas, which occur during periods when a bubble is expanding,' he said.

'Unfortunately, the drawdowns generally arrive with a vengeance. At present, we expect the current cycle to be completed by a market loss on the order of 65-70%.'

Hussman Funds

He added: 'Yes, I know. A drawdown of 65-70% sounds insane and utterly preposterous, but the revulsion to that idea is largely due to pervasive speculative psychology, not historical evidence, cash flows, or fundamentals.'

A Departure from Consensus

Hussman's views differ drastically from those held by some of Wall Street's top analysts.

Morgan Stanley's Mike Wilson, as one example, has said that even though valuations of large-cap growth stocks at the top of the S&P 500 are too high to lend themselves to much near-term appreciation, the market will be driven up 8% next year by surging price action in value and cyclicals as the economy recovers.

Wilson predicted the last two market sell-offs with high precision, and told Business Insider that while the indicators he used to make those predictions 'are still flashing signs of exhaustion,' he's not making a call for even a 10% drop.

As another example, Goldman Sachs has said the S&P 500 will rise next year by 20%.

And JPMorgan has predicted that the market will surge 26% in 2021.

Hussman's track record

Above, we noted that Hussman's right leg is currently tapping — his self-described visceral indicator of a coming sell-off. But to be fair, it's unclear whether his leg has ever ceased to tap.

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 doomsday calls.

But before you dismiss Hussman as a wonky perma-bear, consider his track record, which he broke down in a recent 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.

However, Hussman's recent returns have been less-than-stellar. His Strategic Growth Fund is down about 50% since December 2010, though it's risen more than 11% in the past year.

Still, the amount of bearish evidence being unearthed by Hussman continues to mount. 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 one that Hussman will clearly keep exploring in the interim.