Hussman Weekly Market Comment: The Lesson of the Coming Decade

We continue to observe conditions that fall within the most negative 5% of historical instances, and these conditions (not any inherent preference toward bearishness) are the reason we hold to a defensive outlook here. The concept of a “broken speculative peak” is relevant – our main concern being that risk premiums have been driven to remarkably thin levels, and we are presently observing market action that suggests upward pressure on those risk premiums. As I’ve often noted, a severe market decline is really nothing more than a spike in risk premiums from previously inadequate levels.

As a simple measure of this combination – rich valuations coupled with upward pressures on risk premiums and competing yields – it’s worth considering the current Shiller P/E near 24 (S&P 500 divided by the 10-year average of inflation-adjusted earnings) in the context of rising yields on competing securities. Both the Dow Jones Utility Average and the Dow Jones Corporate Bond Average are down more than 5% from their recent 26-week highs. The last time we saw this combination of weakness in interest-sensitive sectors with the Shiller P/E even above 18 was in September 2008, just before the market collapsed that year. We observed a similar deterioration following overvalued, overbought, overbullish syndromes in January 2000 (though be aware that it took several more months of top formation for the market to decline in earnest) and June-September 1987. This is certainly not the only concern that we have at present, but it illustrates our discomfort with speculative risk-taking here.

As a side note, we’ve seen some arguments disputing the relevance of the Shiller P/E, suggesting that the accounting treatment of writeoffs in recent decades has made this measure obsolete. This might be a more compelling view if other valuation measures such as S&P 500 price/revenue, price/dividend, price/book, and market capitalization to GDP did not all presently indicate exactly the same range of overvaluation as the Shiller P/E does. One of the more intellectually distressing arguments on this front suggested replacing S&P 500 earnings with NIPA (National Income and Product Accounts) profit figures in the calculation of the Shiller P/E. This is an apples-to-oranges calculation, as NIPA figures measure economy-wide profits in dollars and are neither restricted to the S&P 500 nor include the per-share adjustments that index earnings do. Still, one can see why the substitution is superficially attractive: the ratio of NIPA profits to Shiller earnings has surged to the highest level in history in recent years, mirroring similarly elevated profit margins. Unfortunately, even much less breathtaking elevations in NIPA profits / Shiller earnings in the past have been regularly followed by weak subsequent growth in NIPA profits, as profit margins retreat. Moreover, the substitution of NIPA profits into the Shiller calculation substantially weakens, rather than strengthens, its relationship with subsequent S&P 500 total returns.

In any event, we refer to the Shiller P/E mainly because it is an easily accessible shorthand measure that is simple to obtain and calculate. As detailed in Investment, Speculation, Valuation and Tinker Bell, there are numerous other approaches that have a roughly 90% correlation with subsequent 10-year market returns, while many popular approaches (such as the Fed Model) have very little relationship to subsequent returns at all.

On the subject of economy-wide measures, the chart below shows the market value of U.S. nonfinancial equities (from Federal Reserve Z.1 Flow of Funds data) divided by nominal GDP, and the subsequent 10-year S&P 500 annual total return (nominal, right scale, inverted). The present ratio of equity market value to GDP is consistent with an expected 10-year nominal S&P 500 total return of about 3%, which is about the same figure one obtains using the Shiller P/E and other historically reliable measures. Nearly all of this total return can be expected to come from dividend income, suggesting that the S&P 500 index will be little changed, a decade from now, from present levels.