John Hussman: Run of the Mill Outcomes Vs. Worst-Case Scenario

With the Standard & Poor's 500 Index at the same level it set in early November 2014, and the broad NYSE Composite Index unchanged since October 2013, the stock market continues to trace out a massive arc that is likely to be recognized, in hindsight, as the top formation of the third financial bubble in 16 years.

The chart below shows monthly bars for the S&P 500 since 1995. It's difficult to imagine that the current situation will end well, but it's quite easy to lose a full-cycle perspective when so much focus is placed on day-to-day fluctuations. The repeated speculative episodes since 2000 have taken historically reliable valuation measures to extremes seen previously only at the 1929 peak and to a lesser extent, the 1937 peak (which was also followed by a market loss of 50%). Throughout history, at each valuation extreme – certainly in 2000, 2007 and today – investors have openly embraced rich valuations in the belief that they represent some new, modern and acceptable “norm,” failing to recognize the virtually one-to-one correspondence between elevated valuations and depressed subsequent investment outcomes.

Wall Street analysts talk endlessly on financial television about low interest rates “justifying” current valuations, without completing the story that even if this were true (and it’s not – see the links below), these rich valuations still imply predictably dismal future returns on stocks, particularly on a 10- to 12-year horizon. The fact is that the relationship – the direct mapping – between the most historically reliable valuation measures and actual subsequent market returns hasn’t changed a bit in nearly a century.

I emphasize the phrase “historically reliable” because many of the most popular valuation measures vaunted by Wall Street have a strikingly weak correlation with actual subsequent market returns, and that record gets no better when one imputes these measures across an extended historical dataset (see in particular my August 2007 comment Long-Term Evidence on the Fed Model and Forward Operating P/E Ratios, and my May 2015 piece Recognizing the Risks to Financial Stability).

Though corporate earnings are necessary to generate deliverable cash to shareholders, comparing prices to earnings is actually quite a poor way to estimate prospective future investment returns. The reason is simple – most of the variation in earnings, particularly at the index level, is uninformative. Stocks are not a claim to next year’s earnings, but to a very long-term stream of cash flows that will be delivered into the hands of investors over time. Corporate earnings are more variable, historically, than stock prices themselves. Though “operating” earnings are less volatile, all earnings measures are pro-cyclical, expanding during economic expansions and retreating during recessions. As a result, to quote the legendary value investor Benjamin Graham, “The purchasers view the good current earnings as equivalent to ‘earning power’ and assume that prosperity is equivalent to safety.” Not surprisingly, the valuation measures having the strongest correlation with actual subsequent investment returns across history are smoother and serve as better “sufficient statistics” for the relevant long-term cash flows.

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