Hussman Weekly Market Comment: Ockham's Razor and the Market Cycle

Link to: Ockham's Razor and the Market Cycle

We increasingly see investors believing that history is no longer informative, and that the Federal Reserve has finally discovered how to produce perpetually rising markets and can intervene without consequence to support the markets and the economy indefinitely. Maybe it’s no longer true that valuations are related to subsequent returns. Maybe, contrary to all historical experience, reliable measures of valuation that have had a 90% correlation with actual subsequent market returns can now remain at double their historical norms forever, thereby allowing capital gains to be unhindered by any future retreat in valuation multiples as fundamentals grow over time. It’s just that one must also rely on valuations never retreating, because even if earnings grow at 6% annually indefinitely, and the CAPE simply touches a historically-normal level of 16 even 20 years from today, the total return on stocks, including dividends, would still be expected to average only 5% annually over that horizon. That’s just arithmetic.  

Investors should also note the following. At present, the most historically reliable valuation measures average more than 110% above their pre-bubble historical norms. Secular bear market lows don’t occur very often, but when they do, valuations typically average about 50% of pre-bubble norms. Here’s some arithmetic. Assuming constant 6% annual growth in nominal fundamentals, if the stock market was to experience a secular bear market low 25 years from now, the S&P 500 Index would be unchanged from present levels. Checking those numbers is good practice [1.06 * (0.5/2.1)^(1/25) = 1.00]. Market valuations leave no margin for error, even over the long-term.  

Meanwhile, nothing even in recent market cycles provides any support to the assumption of permanently elevated valuations. The only support for it is the desire of investors to avoid contemplating outcomes the same as the market suffered the last two times around. “This time is different” requires a lot of counterfactual assumptions. Ockham’s razor would suggest a nice shave.