Hussman Weekly Market Comment: The Truth Does Not Change According To Our Ability To Stomach It

Our estimate of prospective 10-year nominal S&P 500 total returns has eroded to just 2.3%, suggesting that equities are likely to underperform even the relatively low returns available on 10-year Treasury bonds in the coming decade. Those estimates have had a correlation of over 85% with subsequent 10-year S&P 500 total returns since 1940, and a higher correlation with subsequent returns more recently.

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The stock market is presently at valuations where not only cyclical but secular bear markets have started. A secular bear period comprises a series of cyclical bull-bear periods where valuations gradually work their way lower at each successive cyclical trough. The past 13 years of paltry overall total returns for the S&P 500 have unfortunately corrected very little of the excess in 2000, largely thanks to yet another round of Fed-enabled speculation. We should have learned how these episodes end. At least in 2000 investors had not seen that ending, and even in 2007, the point had not been driven home. There is no excuse today, at least not if one distinguishes between measures that have provided reliable guidance about actual subsequent market returns over the past century, and those that - despite their popular appeal - have not. Though valuations for the S&P 500 are not as rich as 2000 on most measures, valuations for the median stock actually exceed the 2000 peak. From the standpoint of a century of market history, equity valuations are obscene.

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Again, present valuations are less severe than in 2000 for the S&P 500 as a whole, but are actually more severe for the median stock. In 2000, small capitalization stocks were much better valued than larger ones, though that didn’t prevent them from losing a large portion of their value in the bear market that followed.

What we observe today is very broad based overvaluation across asset classes and individual securities. This is why measures that extend beyond the S&P 500 – like the market capitalization of equities / GDP (based on Federal Reserve Z.1 Flow of Funds data) are worse than in 2007 and are approaching the records seen in 2000. It’s why the median price/revenue ratio for S&P 500 stocks is now higher than at the 2000 peak (and is nearly as high if one uses enterprise value/revenue instead of price/revenue). It’s why Value Line now reports the lowest median 3-5 year appreciation potential among all of the stocks it covers - lower than 2000 and 2007, and every point back to the 1960’s.

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Last week, the percentage of bearish investment advisors plunged to just 14.3%, the lowest level in 25+ years. The Shiller P/E (the S&P 500 Index divided by the 10-year average of inflation-adjusted earnings) is now 25.4, and while we use the Shiller only as a readily-available shorthand for other measures, it is certainly better correlated with our actual valuation measures than alternatives like the Fed Model are. Looking over the historical record, the only other instance that bearish sentiment was this low while the Shiller P/E was over 19 was the exact peak of the S&P 500 in January 1973, before the market lost half its value. Looking at the overvalued, overbought, overbullish features that regularly define market peaks, there are only four instances in history when the Shiller P/E was over 19, the market was at a 5-year high, and bearish sentiment was anywhere below 18.5%. These instances were 1972, 1987, 2007, and today. The 2000 peak doesn’t appear because bearish sentiment never moved below 20% that year.

Among the litany of other classic features of a speculative bull market peak, margin debt on the NYSE has surged to the highest level in history, and at nearly 2.5% of GDP, exceeds all but two months in 2000 and 2007. The amount being borrowed to buy stocks on margin is now 26% the size of all commercial and industrial loans in the entire U.S. banking sector. As low-quality, high-risk borrowers rush to take advantage of the present speculative appetite, issuance of leveraged loans (particularly the junkier “covenant-lite” forms) has now hit a record high, already eclipsing the previous record in 2007 at the height of pre-crisis yield-seeking. New equity issuance is also running at the fastest pace since any point except the 2000 bubble peak. At the same time, Bloomberg reports that investors are plowing more into stock mutual funds than at any point since the 2000 bubble peak. Keep in mind how this works - every buyer is matched with a seller in equilibrium, so the same amount of stock is being sold by institutions and other non-retail investors. One doesn’t need to think long to answer who is likely to be the “smart money” in this trade, as the history of surges in retail participation provides a rather firm answer to that question.