So we have to make a distinction. If the Fed launches a fresh policy of extraordinary easing in the next downturn, the appropriate response will depend on whether market internals indicate that investors are inclined toward speculation, or whether they are inclined toward risk aversion. The central consideration here is what I call ‘uniformity’ – when investors are inclined to speculate, they tend to be indiscriminate about it. It’s difficult to get extended market advances without recruiting that kind of uniformity, but it will be important to avoid being sucked into the market in response to Fed easing alone. Historically, initial Fed rate cuts in response to a market downturn have been followed by very negative consequences (after the initial obligatory market pop), because they generally indicate that something has gone wrong.

– John P. Hussman, Ph.D., November 28, 2018

Of all the distinctions that investors might make in the coming few years, one that I expect will serve investors particularly well is the distinction between how the market responds to monetary policy when investors are inclined toward speculation, versus how the market responds when investors are inclined toward risk-aversion.

Though these inclinations are psychological, we can infer them from observable market behavior, because when investors are inclined toward speculation, they tend to be indiscriminate about it. As a result, our best measure of investor psychology is the uniformity or divergence of market action across thousands of stocks, industries, sectors, and security-types, including debt securities of varying creditworthiness. I refer to that broad uniformity or divergence using the word “internals.”

Unlike valuations, where we are extremely open about our methods, our measure of internals is one of the few things I keep “proprietary.” That’s because shifts in internals are very discrete, and one doesn’t want to respond to market behavior at the exact moment everyone else does. That said, I’m very open about the underlying principle: speculation tends to be indiscriminate. Our own methods involve a very broad signal-extraction from market behavior, but the broad features can be captured by examining multiple concepts of “uniformity” – breadth (advancing/declining issues), participation (% of stocks moving jointly), leadership (new highs/lows), price-volume behavior (sponsorship), credit spreads, and similar measures.

The chart below presents the cumulative total return of the S&P 500 in periods where our measures of market internals have been favorable, accruing Treasury bill interest otherwise. The chart is historical, does not represent any investment portfolio, does not reflect valuations or other features of our investment approach, and is not an assurance of future outcomes.

Notice that our measures of market internals were unfavorable for over a year following a negative shift on February 2, 2018. After a brief positive whipsaw, they have turned negative again in recent weeks. The fresh market highs in recent weeks have not, at least yet, been associated with a fresh positive shift in internals. In the context of hypervalued extremes, these poor internals suggest that a “trap door” remains open here. That may change, but rather than trying to predict internals, we respond to shifts when we actually observe them.