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The Truth Does Not Change According to Our Ability to Stomach It - John Hussman

December 09, 2013 | About:
Canadian Value

Canadian Value

Our estimate of prospective 10-year nominal S&P 500 total returns has eroded to just 2.3%, suggesting that equities are likely to underperform even the relatively low returns available on 10-year Treasury bonds in the coming decade. Those estimates have had a correlation of over 85% with subsequent 10-year S&P 500 total returns since 1940, and a higher correlation with subsequent returns more recently. We don’t rely on any single estimation method, and some are more complex discounting models, but a number of very good shorthand methods with similar historical reliability are reviewed in the Valuation section of Investment, Speculation, Valuation, and Tinker Bell. Note that these same valuation measures were quite favorable in 2009, and gave us sufficient room to shift to a constructive stance after the 2000-2002 bear market plunge, while warning of overvaluation at the 2000, 2007 and present instances. Despite other considerations that have been unique to this cycle, our valuation measures haven’t missed a beat.

As a side-note, it’s easy enough to evaluate the all of these methods versus actual subsequent equity returns in a century of historical data. One can demonstrate their reliability against alternatives such as the Fed Model, “equity risk premium” models, and forward-operating P/E ratios (see An Open Letter to the Fed: Recognizing the Valuation Bubble in Equities), as well as measures that use NIPA profits (where a rather egregious bit of analysis that I addressed months ago continues to stagger about like the living dead). Analysts who don’t show their data, and more importantly, don’t demonstrate that their valuation methods are tightly correlated with actual subsequent market returns over the next several years, are simply purveyors of noise. When you realize that the errors of the Fed Model in explaining actual subsequent market returns (in excess of bonds) are 86% correlated with the profit margins that existed at the time of the forecast, it should be clear that the model is not capturing regularities that ought to be captured.

Examining extreme market peaks across history, you’ll usually observe three things: a) the most historically reliable valuation measures will have modestly underestimated the advance over the preceding 10-years, b) those same valuation measures will be projecting dismal subsequent market returns, and c) those valuation measures will be proven right. The converse is generally true at extreme market troughs (see The Siren’s Song of the Unfinished Half-Cyclefor a historical graph that illustrates these regularities). The reason for this is that any market extreme is the endpoint of an unfinished half-cycle. So not surprisingly, when we examine projections from a decade ago, or calculate a 13+year estimate from the 2000 peak, the S&P 500 has briefly outperformed those estimates by several percent annually. These “overshoots” are likely to be corrected in the completion of the full market cycle.

The stock market is presently at valuations where not only cyclical but secular bear markets have started. A secular bear period comprises a series of cyclical bull-bear periods where valuations gradually work their way lower at each successive cyclical trough. The past 13 years of paltry overall total returns for the S&P 500 have unfortunately corrected very little of the excess in 2000, largely thanks to yet another round of Fed-enabled speculation. We should have learned how these episodes end. At least in 2000 investors had not seen that ending, and even in 2007, the point had not been driven home. There is no excuse today, at least not if one distinguishes between measures that have provided reliable guidance about actual subsequent market returns over the past century, and those that - despite their popular appeal - have not. Though valuations for the S&P 500 are not as rich as 2000 on most measures, valuations for the median stock actually exceed the 2000 peak. From the standpoint of a century of market history, equity valuations are obscene.

I fully understand that investors would like to believe 13 years after the 2000 bubble peak (during which time the S&P 500 has achieved annual total returns of scarcely 3% annually) it should be impossible that stocks could be in yet another valuation bubble. Explaining this unfortunate situation to my 17-year old daughter, she quotes Flannery O’Connor - “The truth does not change according to our ability to stomach it.” The S&P 500 was priced in 2000 to achieve what we estimated to be negative total returns over the following decade, and the market did exactly that. But today, a few years past that 10-year mark, the 3% annual total return of the market since 2000 has been achieved only by restoring historically severe valuations. Again, present valuations are less severe than in 2000 for the S&P 500 as a whole, but are actually more severe for the median stock. In 2000, small capitalization stocks were much better valued than larger ones, though that didn’t prevent them from losing a large portion of their value in the bear market that followed.

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