John Hussman - The Delusion Of Perpetual Motion

uncorrected persistence of extreme overvalued, overbought, overbullish syndromes in recent half-cycle, far longer than they have persisted historically. But don’t imagine that these objections will make the total returns of the S&P 500 any better than zero over the coming years. I’m convinced that we’ve addressed the challenges we confronted in the half-cycle since 2009. No doubt, a further diagonal and uncorrected advance would make us no more constructive than we are at present. Still, one might want to review how our approach served us overcomplete market cycles prior to this speculative episode. We certainly expect that the next 7-10 years will include a separate bull market, or even two. So there will undoubtedly be strong investment opportunities along the way, but not at these prices. My impression from history is that the completion of the present market cycle will begin with a panic, and end with yet another.

If we examine data since 1940, the 10-year total return on the S&P 500 has a correlation of about 83% with the CAPE. Including the profit margin embedded in the CAPE as an additional explanatory variable brings this correlation to about 90% (to understand why, see Margins, Multiples, and the Iron Law of Valuation). As Shiller correctly observes, including Treasury bill and 10-year Treasury bond yields as additional variables adds no further explanatory power. Put another way, interest rates do have an impact on the level of valuations, but the resulting valuations are informative – at face value – about the probable level of future market returns.

On a historical basis, the CAPE of over 26 is already quite enough to expect more than a decade of negative real total returns for the S&P 500. Aside from the crashes that followed the 1929, 2000 and 2007 peaks, a very long period of negative real returns also followed the other historical peak in the CAPE near 24 in the mid-1960’s. As noted above, one adjustment to the CAPE that significantly improves its relationship with actual subsequent market returns – as it does for numerous other measures – is to correct for the implied profit margin embedded into the multiple. This is true even though the denominator of the CAPE is based on 10-year averaging. At present, the margin embedded in the Shiller CAPE is more than 20% above the historical average. Adjusting for that embedded profit margin – which, again, produces a historically more reliable indication of actual subsequent S&P 500 total returns – the Shiller CAPE would presently be over 32. That level might make even Professor Shiller question whether stocks should be a material component of portfolios (at least for investors with horizons much shorter than the 50-year average duration of S&P 500 stocks). In any event, even the phrase “lighten up” is problematic for the market if more than a few investors heed that advice.

The ratio of non-financial equity market capitalization to GDP (which has maintained a tight correlation with subsequent 10-year S&P 500 total returns even in recent times) is now about 134%, compared with a pre-bubble norm of 55%. The median price/revenue ratio S&P 500 components easily exceeds, and the average rivals, the levels observed at the 2000 peak. All of this suggests that investors may not appreciate the extent of present overvaluation, lulled once again by the assumption that cyclically-elevated earnings are permanent. Benjamin Graham warned long ago that this assumption is probably the chief source of losses to investors: “The purchasers view the good current earnings as equivalent to ‘earning power’ and assume that prosperity is equivalent to safety.”

Meanwhile, Fed Governor James Bullard observed last week that even the Fed is not inclined to maintain zero interest rate policy indefinitely: “Investors should be listening to the Committee. Of course, you can do what you want.”

Market Peaks Are a Process

John P. Hussman, Ph.D.
June 2, 2014

“Regardless of very short-term market direction, it is urgent for investors to understand where the equity markets are positioned in the context of the full market cycle. While the most extreme overvalued, overbought, overbullish, rising-yield syndrome we define has generally appeared only at the most wicked market peaks in history, investors have ignored those conditions over the past year. We can’t be certain when the deferred consequences will emerge. But a century of market history provides strong reason to believe that any intervening gains will be wiped out in spades.

“It’s instructive that the 2000-2002 decline wiped out the entire total return of the S&P 500 – in excess of Treasury bills – all the way back to May 1996, while the 2007-2009 decline wiped out the entire excess return of the S&P 500 all the way back to June 1995. Overconfidence and overvaluation always extract a terrible payback.

“It may also be helpful to remember that market peaks are a process, not an event. In the presence of a broad range of reliable valuation metrics uniformly at more than twice their historical norms, coupled with the most severe overvalued, overbought, overbullish, rising-yield syndrome we define, it is instructive how shorter-term action has evolved near those points. Outside of today and 1929, the other two instances are, not surprisingly, 2000 and 2007. The chart below provides a more granular reminder that market peaks are often a broad process and can involve hard initial downturns and swift recoveries. The ultimate follow-through provides some insight regarding the full scale of our concerns.”

It is Informed Optimism To Wait for the Rain – Hussman Weekly Market Comment 3/10/14

I should emphasize that the circled areas on the chart above aren’t chosen arbitrarily but reflect points where similar overvalued, overbought, overbullish extremes were observed. As I’ve noted in recent weeks (see The Journeys of Sisyphus and Exit Strategy), depending on how tightly we define this syndrome the 1972 and 1987 peaks can also be captured among the set of extremes that include 1929, 2000, 2007 and today. Remember that at a fine resolution, the full syndrome sometimes doesn’t precisely align with the final market high. Still, we remain convinced that any near term continuation we observe in this advance is likely to appear quite insignificant in the context of what the market loses over the completion of the cycle.

It’s fascinating how investors come to forget that markets move in cycles and not perpetual diagonal lines. As value investor Howard Marks wrote in The Most Important Thing, “Rule number one: most things will prove to be cyclical. Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.” A normal, run-of-the mill cyclical bear market wipes out more than half of the preceding bull market advance. We should not be surprised at all to see the S&P 500 back at 2010 levels or below over the completion of the present cycle. From a valuation standpoint, we estimate that the S&P 500 Index would have to fall to the 1000 level to bring prospective 10-year nominal total returns toward their historical norm of about 10% annually. With the exception of the 2000-2002 bear market, valuations have typically been lower, and prospective returns higher, at cyclical troughs thr oughout recorded history (even in data prior to the 1960’s when interest rates were similarly depressed). Not that we need to forecast such an outcome, and certainly not that we would require anything near historical valuation norms to encourage a constructive stance, provided support from other factors. As always, the strongest prospective market return/risk profile is associated with a material retreat in valuations followed by an early improvement in broad measures of market internals….