Hussman Weekly Market Comment: An Open Letter to the FOMC: Recognizing the Valuation Bubble In Equities

How does one establish the value of a long-lived asset? Hopefully, that question stirs the economist in all of you, and you immediately respond that every security is a claim on some long-term stream of cash payments (including any terminal value) that the holder can expect to receive over time. If price is known, the discount rate that equates price to the present value of expected future payments can be interpreted to be the expected long-term return of that security. This is how one calculates the yield-to-maturity on a long-term bond, for example. Conversely, we can make assumptions about the long-term return that investors will require over time and then calculate an implied price. Discounting the expected long-term stream of cash flows using some required long-term return results in a “fair value” that quietly incorporates those underlying assumptions.

Of course, nobody likes to discount an entire stream of expected payments, so investors create shortcuts. The most common shortcut is to compress all of the relevant cash flows and discount rates into a “sufficient statistic.” So for example, if we have a perpetuity with price $P that throws off cash flow $C every year forever, the ratio C/P is a sufficient statistic for the expected long-term rate of return, and everything knowable about valuation can be neatly summarized by that ratio. Nice economic assumptions about constant growth rates, returns on invested capital, payout ratios, and other factors encourage similar approaches in the equity market. So we look at price/earnings ratios based on a single year of earnings and immediately believe we know something about long-term value.

But valuation shortcuts are only useful if the “fundamental” being used is representative of the entire long-term stream of cash flows that will be delivered into the hands of investors. And it’s precisely here where the FOMC may find a careful review of the evidence to be useful.

The chart below is from one of the best tools that the Fed offers the public, the Federal Reserve Economic Database (FRED). The chart shows the ratio of corporate profits to GDP, which is presently at a record. The fact that profits as a share of GDP are more than 70% above their historical norm should immediately raise a question as to whether current year earnings or next year’s projected “forward earnings” should be used as a sufficient statistic for long-term cash flows and equity market valuation without any further reflection. Then again, more work is required to demonstrate that such an approach would be misleading. We’re just getting warmed up.