By John P. Hussman, Ph.D:
It is important to recognize that the S&P 500 is presently only about 13% below its April peak, and the word "only" deserves emphasis. Our valuation impressions align fairly well with those of Jeremy Grantham at GMO, who puts fair value for the S&P 500 "no higher than 950" - a level that we would still associate with prospective 10-year total returns of only about 8% annually. I would consider investors to be very fortunate if the market does not substantially breach that level in the coming 12-18 months. Wall Street continues its servile attachment to forward operating earnings, seemingly unconscious that the perceived "norms" for the resulting P/E are artifacts of a bubble period. The fact is that historical periods of overvaluation and poor subsequent long-term returns correspond toforward operating P/E multiples anywhere above 12, while secular buying opportunities such as 1950, 1974 and 1982 map to forward operating multiples of only 5 or 6 (based on the strong correlation but downward-biased level of forward operating P/E ratios, when compared with multiples based on normalized earnings - see Chutes and Ladders for a graphic).
The composite of recession warning evidence we observe here (year-over-year GDP growth of just 1.6%, S&P 500 below its level of 6 months earlier, widening credit spreads versus 6 months earlier, yield curve spread at 2.2%, Purchasing Managers Index at 50.9, year-over-year nonfarm payroll growth below 1%) falls into a Recession Warning Compositethat has been observed in every recession since 1950, and has never been observed except during or immediately preceding a recession. European growth has also stalled abruptly, and the latest read on consumer confidence (University of Michigan) collapsed to levels not seen since 1981. It is worth noting that while the weakness in the summer of 2010 generated enough indications of oncoming recession to prompt the Federal Reserve to kick the can down the road by initiating QE2, the Purchasing Managers Index never deteriorated below 54.4, and the print on real GDP was still 3.5% year-over-year growth. Needless to say, our concern about oncoming recession is even stronger today.
Without question, one of the notions buoying Wall Street optimism here is the hope that the Fed will pull another rabbit out of its hat by initiating QE3. That's a nice sentiment, but it does overlook one minor detail. QE2 didn't work.
Actually, that's not quite fair. The Federal Reserve was indeed successful at provoking a speculative frenzy in the financial markets, which has now been completely wiped out. The Fed was also successful in leveraging its balance sheet by more than 55-to-1 (more than Bear Stearns, Lehman, Fannie Mae, Freddie Mac, or even Long-Term Capital Management ever achieved), and driving the monetary base to more than 18 cents for every dollar of GDP - a level that requires short-term interest rates to remain below about 3 basis points in order to maintain price stability ( see Charles Plosser and the 50% Contraction in the Fed's Balance Sheet ). The Fed was indeed successful in provoking a wave of commodity hoarding that affected global supplies and injured the poorest of the poor - particularly in developing countries. The Fed was successful in setting off a very predictable decline in the value of the U.S. dollar. The Fed was successful in punishing savers and the risk averse, and driving investors to reach for yield in risky investments that they would normally avoid were it not for the absence of yield. The Fed was successful in provoking those with strong balance sheets to pay down existing higher interest-rate debt, and in creating an incentive for those with weak balance sheets to issue more of it at low rates, resulting in a simultaneous deterioration of credit quality and compensation for risk in the financial system. The Fed was successful at boosting the trading profits of the banks that serve as primary dealers, by announcing precisely which securities it would be buying prior to Treasury auctions, and buying them on the open market a few days later from the dealers that acquired them. The Fed was successful in creating a portfolio of low yielding securities that will be almost impossible to disgorge without capital losses unless the Fed holds them to maturity. On proper reflection, the list of the Fed's successes from QE2 is nothing short of stunning.
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