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John Hussman - Pushing Luck

February 03, 2014 | About:
Canadian Value

Canadian Value

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The latest data from the NYSE shows equity margin debt at a new all-time high. Relative to GDP, the current 2.6% level was eclipsed only once – at the March 2000 market peak. In the context of the most extreme bullish sentiment in decades, and reliable valuation metrics about double their historical norms prior to the late-1990’s bubble (price/revenue, market cap/GDP, Tobin’s Q, properly normalized price/forward operating earnings, price to cyclically-adjusted earnings), we view present market conditions as dangerously speculative.

Before it’s too late, I should note – as I also did at the 2007 market peak just before the market collapsed – thatunadjusted forward operating P/E ratios and the Fed Model are both quite unreliable indications of value or prospective returns (see Long-Term Evidence on the Fed Model and Forward Operating P/E Ratios).

Even the shallow 3% retreat from the market’s all-time highs may be enough to prompt a reflexive “buy-the-dip” response in the context of extreme bullish sentiment here, as the S&P 500 bounced off of a widely monitored and steeply ascending trendline last week that connects several short-term market lows over the past year. Regardless, the potential for short-term gains is overwhelmed by the risk of deep cyclical and secular losses. We presently estimate prospective 10-year S&P 500 nominal total returns averaging just 2.7% annually, with negative expected total returns on every horizon shorter than 7 years.

Could the stock market’s valuation really be double its historical norm? Yes, this is presently the case for numerous historically reliable measures, including price/revenue, market cap/GDP, Tobin’s Q, and a variety of properly normalized earnings-based measures.

[Geek’s Note: Think of the market’s overvaluation this way. Suppose that a security achieves a 10% long-term return when it is priced at “fair value,” and that the security is expected to trade at fair value X a decade from today. In order to achieve a 10% return over the coming decade (ignore dividends for a second), the security must be priced at X/(1.10)^10 = 0.386X today.  Now suppose that the security is actually priced to achieve annual returns of just 2.7% over the coming decade. In that case, the price would be X/(1.027)^10 = 0.766X today. Of course 0.766/0.386 is 1.98, so at a 2.7% 10-year expected return, the price is 98% above the level at which the security would achieve a 10% rate of return.

Alternatively, if one argues that a 5% annual rate of return would be perfectly acceptable for the next decade, it follows that the price should be X/(1.05)^10 = 0.614X. In that case, the security is only 25% overvalued at 0.766X. Indeed, if one argues that a 2.7% annual rate of return is perfectly acceptable, it follows that the security is appropriately priced at 0.766X. To say that we view stocks as strenuously overvalued is to assert that a 2.7% annual return for the S&P 500 over the next decade is unacceptable relative to the probable risks, even given currently depressed interest rates. But that’s how stocks are priced here.

One can show that similar calculations apply in the presence of cash payouts. For example, begin with an arbitrary payout growing at 6% over time. Suppose that for a decade the expected total return k = 2.7%, with k = 10% thereafter. Under those assumptions, the security will be priced 82% above the level at which it would achieve a consistent 10% rate of return].

There are certain points in history where the projections of S&P 500 total returns have differed somewhat depending on which fundamental measure one uses. At present, a wide range of valuation methods that are actually historically reliable show very little variation. Uniformly, and across fundamentals that have reliably correlated with actual subsequent market returns, we project likely S&P 500 total returns in the range of 1-3% annually over the coming decade. Given a 2% dividend yield, this implies that we fully expect the S&P 500 to be no higher a decade from today than it is at present.

These are, of course, the same methods that led us to correctly anticipate a decade of negative total returns in 2000, and significant market weakness in 2007. In contrast, note that these same methods were quite favorabletoward equities in 2009 (our stress-testing concerns were not driven by valuations). A passive, equally balanced portfolio of stocks, bonds, and cash can be expected to return about 2% annually over the coming decade. If this seems to be an untenable long-term rate of return, understand that the security prices underlying those expected returns are equally untenable. Also, remember that historical evidence is sufficient to distinguish between competing valuation approaches.

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None of this ensures that stocks will decline rather than advance over the near term, but any expectation of adequate longer-term returns in equities from present valuation levels taxes the historical evidence. What accelerates our concerns is the extreme level of speculation in the present market environment. For example, the chart below shows NYSE margin debt both in dollar terms and relative to nominal GDP. We use GDP here because margin debt to GDP has a much higher correlation with actual subsequent market returns than say, margin debt / market capitalization (which destroys information by muting the indicator exactly at points when prices are extremely elevated or depressed). That said, the main usefulness of this measure isn’t for any fixed correlation with subsequent returns – numerous valuation measures do much better – but for its extremes. This is particularly true when margin debt advances rapidly over a span of several quarters relative to prices, GDP and other measures.

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Canadian Value
http://valueinvestorcanada.blogspot.com/

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