Reply #26: Skews and Smiles (Hussman)

[54anickel]

http://www.hussmanfunds.com/wmc/wmc050718.htm

snip>

Hot Potato and Musical Chairs

The skew implied by options prices suggests the sort of considerations that investors should have at present. With valuations very rich, bullish sentiment high, and stocks generally overbought, there's a certain momentum to the market that makes it likely – in terms of probability – that stocks will be higher in the weeks ahead. Unfortunately, there's a small probability of some real damage, and that's what keeps us defensive.

Being defensive isn't the most comfortable position, of course, because most probably we'll be disappointed to miss some amount of gains in the market. But that small probability of a large loss matters here, particularly because as I've noted in numerous weekly comments, whatever gains that the market generates at this point are unlikely to be durable. A moderate market decline without much internal damage might make it reasonable to accept a limited amount of market risk, but given the market's present overbought condition, it makes sense to tread lightly here.

If you listen to the tenor of investment strategists here, the basic message sounds a lot like what we heard in the late 1990's: stocks may not be priced to deliver strong returns on a sustained basis, and there are substantial risks in the longer-term picture, but for now, things seem to be going well and so there's no need to be defensive just yet.

Famous last words: The light's still yellow. Punch it.

Essentially, investors are playing hot potato and musical chairs here. Smelling smoke in the crowded theatre, but with the aisles still fairly empty, not willing to miss any of the show until somebody yells fire. It's a dangerous game.

more...