Hussman Weekly Market Comment: Anatomy of a Bubble
Presently, the Shiller P/E stands at 24. Be careful how you interpret the data in the table for Shiller P/E's above 24, since these levels were almost never observed in data prior to the late-1990's market bubble. You can see the odd effect of the bubble on the P/E categories above 20. The recent tendency for high valuations to move even higher over the short-term, coupled with the rapid recovery of much of the 2008-2009 loss, creates a "hump" in the 5-year profile - average returns first decline as valuations increase, and then actually improve for the 20-24 bracket. This is an artifact of recent years, and appears neither in pre-1995 data nor in 10-year return data.
Indeed, outside of the bubble period since the late 1990's, the only historical instance of Shiller P/Es materially above 24 was between August and early-October of 1929. The closest we got to 24 in post-war data was in mid-1965. While prices went on to achieve moderately higher levels (lagging earnings growth, so that the Shiller multiple fell), the mid-1965 valuation peak is widely viewed as the starting point for a 17-year "secular" bear market during which the S&P 500 achieved total returns of less than 5% annually through 1982, despite severe inflation. That's a good reminder that stocks are not a very good inflation hedge during periods when inflation is rising, particularly when stock valuations are already elevated and are priced to achieve poor returns. Stocks only "benefit" from inflation during hyperinflations and during sustained and anticipated inflations. In other cases, the eventual adjustments in economic activity and valuations overwhelm the "beneficial" effect of inflation on earnings.
The implication of this data for long-term returns is clear. With the Shiller P/E presently at 24, we observe about the same implications for 10-year S&P 500 total returns as we obtain from our broader valuation methods (expected total returns averaging about 3.5% annually). Still, the actual course of total returns will depend on whether valuations become even more extended over the next 5-10 years, or if they contract instead. Even if one includes data from the late-1990's bubble, the probability of rising P/E multiples from these levels is less than 1-in-5.
Still, if one wishes to bet on a bubble, there is no reason set in stone that the market cannot achieve further gains. The question investors should ask, however, is whether confident prospects for a radiant economic future are likely to capture the imaginations of investors to anywhere near the extent that we observed during the late 1990's. The answer matters, because if we exclude the bubble period, the historical probability of rising P/E multiples from present levels effectively drops to zero - similar valuations were always followed by a contraction in multiples.
