WARNING: stocks may be about to collapse

Now that the Europe crisis is solved and volatility has disappeared and stocks just climb higher every day despite high valuations and mediocre economic data, it’s worth considering that this state of affairs may not last forever.

Fund manager John Hussman, for one, is freaked out enough by the current mix of conditions that he has gone so far to issue a “warning” that stocks may be about to collapse.

Now, John Hussman would be the first to admit that precisely timing such crashes is basically impossible, so don’t guffaw at him if stock prices are higher a month from now.

In fact, don’t guffaw if stock prices are higher six months from now and a year from now. Predicting stock prices over the short- and intermediate term is a highly uncertain business, and those who guffaw are generally setting themselves up for a fall.

Anyway, here’s Mr. Hussman, who says that conditions like today’s have generally been followed by a 25% crash within 6 months:

Increasingly… we have observed sets of conditions that are so heavily skewed toward bad outcomes that they deserve the word “warning” (see Extreme Conditions and Typical Outcomes near the 2011 peak, Don’t Mess with Aunt Minnie before the 2010 market break, Expecting a Recession in late 2007, A Who’s Who of Awful Times to Invest at the 2007 market peak, and our shift from a modestly constructive investment position to a Crash Warning in October of 2000).

While the downturns that followed have provoked increasingly large and desperate actions of central banks to kick the can down the road by preventing debt restructuring and financial deleveraging (in some cases by violating legal constraints – see The Case Against the Fed ), the fact is that the S&P 500 has achieved a total return of just 1.2% annually over the past 12 years, as a predictable outcome of rich valuations and still-unresolved economic imbalances…

Once again, we now have a set of market conditions that is associated almost exclusively with steeply negative outcomes. In this case, we’re observing an “exhaustion” syndrome that has typically been followed by market losses on the order of 25% over the following 6-7 month period (not a typo).

Worse, this is coupled with evidence from leading economic measures that continue to be associated with a very high risk of oncoming recession in the U.S. – despite a modest firming in various lagging and coincident economic indicators, at still-tepid levels. Compound this with unresolved credit strains and an effectively insolvent banking system in Europe, and we face a likely outcome aptly described as a Goat Rodeo.

My concern is that an improbably large number of things will have to go right in order to avoid a major decline in stock market value in the months ahead. We presently estimate that the S&P 500 is likely to achieve a 10-year total return (nominal) of only about 4.7% annually, which reduces the likelihood that further gains will be durable even if they persist for a while longer. In the context of present valuations and a probable Goat Rodeo in the months ahead, my impression is that the recent market advance may be a transitory gift.

Go ahead and laugh. But if stocks do crash don’t come whining that no one warned you.

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