Expert Warns of 64% Drop As Bearish Signals Flash

• John Hussman warns that valuations, investor sentiment, and market technicals are poor right now.
• He believes that the combination could mean weakness for stocks in the days ahead.
• Hussman said stocks could end up falling 64% peak-to-trough this market cycle.

John Hussman — the notorious bubble sage who called the stock market crashes in 2000 and 2008 — says there’s a special cocktail of market conditions right now that spell trouble. 

Its three main ingredients? High valuations, poor investor sentiment, and overextended market technicals.

Investors have been sipping on a mix of high valuations and low investor sentiment for a while now, according to Hussman. But overextended technicals like the ones he’s watching today were most recently part of the recipe in November 2021, just weeks before the market’s all-time-high. 

“The last time we observed this combination to a similar degree was in November 2021, shortly before the S&P 500 lost a quarter of its value,” Hussman wrote in a July 23 note. “Despite enthusiasm about the market rebound since October, I remain convinced that this initial market loss will prove to be a small opening act in the collapse of the most extreme yield-seeking speculative bubble in US history.”

A recipe for stock market disaster

On valuations, Hussman likes to compare total market cap of non-financial stocks to total revenue of non-financial stocks. He says it’s the most reliable indicator of future market returns he’s found.

While it’s off of all-time-highs, the metric is still at some of it’s most elevated levels in history — levels associated with -4% average annualized returns over the next 12 years.

The relationship between this valuation measure and subsequent returns is illustrated below. Typically, the lower the valuation (the horizontal axis), the higher the future returns are (vertical axis). 

And then there’s investor sentiment, or what Hussman calls “market internals.” It’s basically a measure of market breadth, or how many stocks are rallying at the moment. Weak breadth is a signal that investors are bearish on a majority of individual stocks in the market. 

Here’s Hussman’s proprietary measure, illustrated by the red line. When it goes flat, stocks (blue line) tend to perform poorly. 

How can investor sentiment be poor with the market ripping back toward its all-time-high? One explanation could be that while investors aren’t inclined to put money into a majority of stocks in the S&P 500, they’ve been more than willing to plow money into a small group of big tech stocks at the top of the index as those companies race to develop artificial intelligence technology.

That could be what’s driving the technical issues that Hussman has spotted. His criteria for technical overextension include an S&P 500 14-day relative strength index above 70, at least a 4% rate-of-change for the S&P 500 in the last 14-day period, and the S&P 500 at least 4.5% above its 50-day average. 

As of July 23, all of these criteria were met — and when that happens, it usually indicates downside in the near future.

The chart below shows advances and declines for the S&P 500 in the 40 trading sessions after these criteria have been met.