Crash ‘Risk’ Is Soaring: “This Is Where They Lost Their Minds”…”The collapse is fundamentally due to the unstable position; the instantaneous cause of the crash is secondary.”

Tuesday, January 30, 2018
By Paul Martin

from John Hussman’s Weekly Market Comment,
Tue, 01/30/2018

Last week, the U.S. equity market climbed to the steepest valuation level in history, based on the valuation measures most highly correlated with actual subsequent S&P 500 10-12 year total returns, across a century of market cycles.

As Didier Sornette correctly observed in Why Markets Crash,

“The collapse is fundamentally due to the unstable position; the instantaneous cause of the crash is secondary.”

My sense is that investors are going to learn this again the hard way.

On the accelerating slope of the current advance
Speaking of Didier Sornette, I’ve periodically discussed his concept of “log periodic power-law” price behavior, which has accompanied speculative episodes in numerous markets and often precedes inflection points or collapses. This structure is based on a purely mathematical fit to price behavior, and does not reflect any valuation considerations. It’s not part of our own investment discipline, but we occasionally fit the log-periodic structure to price behavior when market movements are particularly extreme.

In recent years, those structures have generally identified inflection points of flat or correcting prices, but certainly not crashes in the S&P 500. Given the increasingly steep slope of the current market advance, along with the most extreme valuations in history and the most lopsided bullish sentiment in more than three decades, it’s quite possible that this instance will be different. In any event, the underlying “arbitrage” considerations described by Sornette are worth reviewing here.

In 2000, as the tech bubble was peaking, Nobel laureate Franco Modigliani observed that the late stages of a bubble can be “rational” in a certain sense, provided that investors are inclined to self-reinforcing behavior.

Imagine a market that you fully believe to be overvalued and at risk of a market crash. Indeed, let’s say that there is a defined probability of a crash, which increases rapidly as the pitch of the market advance becomes more extreme. Should you sell? Well, it depends. Given that an immediate crash is not certain, a speculator must, in each period, weigh the potential gain from holding a bit longer against the potential loss from overstaying. Sornette uses a similar argument to describe a speculative bubble advancing toward its peak (italics mine):

“Since the crash is not a certain deterministic outcome of the bubble, it remains rational for investors to remain in the market provided they are compensated by a higher rate of growth of the bubble for taking the risk of a crash, because there is a finite probability of ‘landing smoothly,’ that is, of attaining the end of the bubble without crash.”

The Rest…HERE

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