There's a general relationship in physics called Hooke's Law, which applies to springs: “as the extension, so the force.” My impression is that the stock market behaves much the same way. When investors are very skittish, the market may behave like a very loose rubber band, generating little tension even as it moves significantly away from fair value. But as risk aversion abates, the tension becomes much more like a stiff spring, and the potential to return forcefully toward normal valuations becomes enormous, particularly when the distance from fair value is large.
[Geek's Note: Adding up the cumulative tension described by Hooke's Law gives you a measure of the “potential energy” stored in the spring, which is proportional not to the distance the spring is pulled, but to the square of that distance. This observation has a nice analogy to finance, in terms of how investors should scale into a falling market. Taking the basic dividend discount model as an example, if the growth rate is 6% and the initial yield is 3%, it takes a 25% drop to increase long-term returns from 9% to 10%. From there it takes another 20% drop (40% cumulative) to increase long-term returns to 11%. From there, it takes a drop of 16.7% (50% cumulative) to increase long-term returns to 12%.]
For those who may not remember, Hooke's Law was named after the the physicist Robert Hooke, who was a contemporary of Isaac Newton. Hussman's mention of Hooke reminds me of a comment a friend of mine made years ago, when we were both students in a philosophy class on Baruch Spinoza. The class was mainly about Spinoza, but also covered the work of other rationalists of the same period, such as Gottfried Leibniz. Newton came up at one point during the class, because of a dispute Leibniz had with the Newtonians (Newton wouldn't correspond with Leibniz directly). My friend mentioned that Newton's famous quote, "If I have seen farther than others it is because I have stood on the shoulders of giants" was actually meant as a dig at Robert Hooke, who happened to be a hunchback. I don't know if that's true, but Hooke and Newton did have a bitter rivalry1.
Back to Hussman's commentary, the paragraph below is consistent with comments made by Jim Rogers on CNBC Europe last week, as we noted in a recent post ("Jim Rogers on CNBC Early This Morning"),
Given the enormous expansion of government liabilities we are observing worldwide, it is unlikely that we will observe a long-term absence of inflation once the recent drop in monetary velocity abates. “Monetary velocity” declines when investors hoard government liabilities as safe havens – this suppresses inflation pressures by supporting the value of government liabilities, including currency. But velocity can also shoot higher once credit fears subside. So one of the casualties of easing credit fears is likely to be weakness in the U.S. dollar, and a concurrent strengthening in commodities – particularly precious metals, which serve as a currency substitute. Given the pricing of precious metals shares here, it would not be unexpected to see the XAU roughly double within the next 12 months from these levels.
1Update: My friend offered me the following elaboration via e-mail,
Here are a couple of links, 'verifying' the claim. 'Course with the Internet, you never know...
http://boleo.wordpress.com/2008/02/11/standing-on-the-shoulders-of-giants/ (this is a long one, but traces the origins of the saying before Newton)
...but, I didn't doubt its veracity, because I heard it from a very reliable source: Dr. Jerry Lettvin, he of 'What the Frog's Eyes Tells the Frog's Brain' fame (a seminal paper that eventually led to the development of modern-day cognitive science studies).
He taught an honors seminar at Rutgers on Leibniz, which a friend of mine was taking at the time. We had tea at Jerry's house in Highland Park once. He is a fascinating character, to say the least:
This'll round out your post-