Hussman Weekly Market Comment: Sitting Ducks

The present market context is this: from a valuation standpoint, virtually every reliable measure of market valuation we observe is now within the highest 1% of historical observations prior to the late-1990’s bubble. “Reliable” in this context refers to valuation measures that are well-correlated with actual subsequent market returns. These measures include price/revenue, price/book, various cyclically-adjusted price/earnings multiples, and market capitalization/GDP, among others. We’ll discuss valuations first, with the caveat that in practice, the most reliable effect of valuations is on long-term returns. The effect of valuations on shorter-horizon returns cannot be separated from other important factors; particularly the quality of market internals and the presence (or absence) of an overvalued, overbought, overbullish syndrome of conditions. Those factors can either mute or amplify the effect of valuations on subsequent market returns, but only for a while.

At its recent high of 24.6, the Shiller P/E (the S&P 500 divided by the 10-year average of inflation-adjusted earnings) matched the level that was observed in September 1929, exceeded the peak of 23 reached in March 1937 (the S&P 500 lost half of its value over the following year), matched the extreme of May 1965, which ushered in a 17-year secular bear market, and significantly exceeded the level of 19.8 seen at the August 1987 peak.

What draws complacency, however, is that valuations are significantly lower here than they were at the 2000 market peak. It doesn’t seem to matter that from the 2000 market peak to the present, the S&P 500 has achieved a nominal total return of just 2.7% annually, and even then only by re-establishing the present strenuous valuation extremes. It also doesn’t seem to matter that 2000 ushered in a decade that included two 50% market declines; one in 2000-2002 that wiped out the entire total return of the S&P 500, in excess of Treasury bills, all the way back to May 1996, and one in 2007-2009 that wiped out the entire total return of the S&P 500, in excess of Treasury bills, all the way back to June 1995.

A second feature that draws complacency is that the Shiller P/E broke above 27 at the late-2007 market peak, just before the market lost 55%, making present valuations seem not-so-high by comparison (“a Shiller P/E of just 24.6? We spit at your Shiller P/E of 24.6!”)

A third feature that draws complacency is that profit margins are about 70% above their historical norms, making raw P/E ratios (particularly those based on “forward operating earnings”) seem fairly reasonable. Understand that the use of raw forward operating P/E ratios implicitly assumes that these profit margins will remain at the most extreme levels in history forever. That’s the essential problem with using a single year of earnings as the basis for stock valuations. Stocks are a claim on a very long-term stream of future cash flows that will be distributed to shareholders over time, and P/E ratios are simply a shorthand. P/E ratios are useful only to the extent that the earnings measure being used is reasonably representative and informative about the long-term stream of cash flows – what might be called a “sufficient statistic.” I made the same observation (to no avail) at the 2007 peak (see Long-Term Evidence on the Fed Model and Forward Operating P/E Ratios). Investors who passively accept Wall Street’s never-ending pitch that “stocks are cheap on forward earnings” without attention to embedded profit margins are the sitting ducks of the investment world.

A final feature that draws complacency is that stocks were already overvalued three years ago, when the market was at lower levels, so to see stocks advance in the face of overvaluation (albeit only because of extraordinary monetary policy) seems to negate the entire basis for concern. I doubt that any of these gains will actually be retained by investors over the completion of the present market cycle. It isn’t difficult to see how badly this sort of complacency has injured investors in previous cycles, but there's no denying that stocks were overvalued some time ago, and stocks have advanced to even greater valuation extremes. The market could not have reached the level of valuation it set in 1929 if the same thing did not happen then. But, here we are. It's worth remembering how brutally those prior overvaluations punished speculators who held out for the last sip of punch.