January 13, 2014 Hovering With an Anvil  John Hussman, Ph.D.


On valuation, we continue to see extremes in a broad range of measures that are very well correlated with actual subsequent market returns. Of course, there are some measures like the “Fed Model” (forward earnings yields less 10-year Treasury yields) that are fairly benign, and suggest no valuation concerns at all. The problem is that these alternative models don’t perform nearly as well in explaining actual subsequent market returns. Much of the reason for that is that they take profit margins at face value even when they are at record levels.

We can calculate the historical errors of various valuation models in forecasting actual subsequent 7-10 year market returns. A good model should have random errors – that is, the errors should not themselves be predictable based on data that was readily available at the time. For the “equity risk premium” models that Janet Yellen and Alan Greenspan often reference as evidence that stocks are not overvalued, it turns out that theerrors of these models have a correlation of about 85% with profit margins that were observable at each point in time. In other words, these models make large and systematic errors because they fail to account for the cyclical variation of profit margins over time (see An Open Letter to the FOMC: Recognizing the Valuation Bubble in Equities, andThe Coming Retreat in Corporate Earnings).

A few quick charts will bring some of our present concerns up to date. The chart below shows the ratio of nonfinancial equity market capitalization to GDP. Again, this measure is about twice its pre-bubble norm, and is presently associated with an expectation of negative total returns for the S&P 500 over the coming decade. Measures based on properly normalized earnings are a little bit more favorable, with the overall outcome that we broadly expect nominal total returns for the S&P 500 of about 2.3% annually over the coming decade, with negative total returns on horizons of less than about 7 years.