Valuation and Speculation: The Iron Laws, by John P. Hussman

There are three primary long-term investing decision parameters: market, investment, and price. John Hussman makes a strong case that the US equity market is one investors are best advised to avoid right now. From Hussman’s weekly market comment at

There are two central considerations in investing that, when used in combination, have been the source of virtually every major success I’ve had in 30 years as a professional investor, and when inadvertently missed or underappreciated, have been the source of virtually every significant disappointment.

The first is what I’ve often called the Iron Law of Valuation: every security is a claim on an expected stream of future cash flows, and given that expected stream of future cash flows, the current price of the security moves opposite to the expected future return on that security.The higher the price an investor pays for that expected stream of cash flows today, the lower the return that an investor should expect over the long-term. Particularly at market peaks, investors seem to believe that regardless of the extent of the preceding advance, future returns remain entirely unaffected. The repeated eagerness of investors to extrapolate returns and ignore the Iron Law of Valuation has been the source of the deepest losses in history (see Margins, Multiples, and the Iron Law of Valuation).

The second consideration, however, is equally important over any horizon other than the long-term. It deserves its own name, and I’ll call it the Iron Law of Speculation: The near-term outcome of speculative, overvalued markets is conditional on investor preferences toward risk-seeking or risk-aversion, and those preferences can be largely inferred from observable market internals and credit spreads. In the long-term, investment outcomes are chiefly defined by valuations, but over the shorter-term, the difference between an overvalued market that becomes more overvalued, and an overvalued market that crashes, has little to do with the level of valuation and everything to do with investor risk preferences (see A Better Lesson than “This Time is Different”).

If you have the long-term available to you, there’s nothing particularly wrong with being a value investor. Over the long-term, disciplined, historically-informed, value-conscious analysis pays off. But over shorter horizons, I promise from personal experience that it will periodically be the bane of your existence. I’ve learned that lesson twice: once during the late-1990’s valuation bubble, when I developed our methods of inferring risk preferences from market internals, credit spreads, and other risk-sensitive factors, and then again – as the inadvertent result of our awkward transition from our successful pre-2009 methods to our (hopefully equally or more successful) present methods of classifying market return/risk profiles. The simple fact is that the ensemble methods that came out of our 2009-2010 stress-testing against Depression-era data included all of those risk-sensitive measures, but not sufficiently to deal with a central bank bent on intentionally fomenting the third valuation bubble in 15 years. We ultimately imposed those bubble-tolerant considerations as an overlay to our methods in mid-2014.

So if you genuinely want to learn something from our experience during the recent half-cycle, it’s not to discard the Iron Law of Valuation, but to couple your awareness of valuation with an understanding of where investor preferences toward risk are from the standpoint of the Iron Law of Speculation. I had very vocal concerns about valuation during the tech bubble and the housing bubble, well before they burst. But it was a specific combination: extreme valuation coupled with fresh deterioration in market internals – the same combination we observe presently – that provided us with timely evidence that market conditions had shifted to urgent risk at what in hindsight turned out to be the very beginning of the 2000-2002 and 2007-2009 collapses. Those collapses wiped out the entire total return of the S&P 500 – in excess of Treasury bills – all the way back to May 1996, and June 1995, respectively, despite aggressive Fed easing in both instances. Don’t imagine that the current bubble will avoid a similar completion.

To continue reading: Valuation and Speculation: The Iron Laws

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