Second-Level Thinking: John Hussman Responds to Howard Marks


While I am a very great admirer of Howard Marks, his fairly sanguine view of equities here seems inconsistent with what he calls “second-level thinking” about how securities are valued, and is almost certainly inconsistent with his observation that “Rule number one, most things will prove to be cyclical. Rule number two, some of the greatest opportunities for gain and loss come when people forget rule number one.”

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Second-level thinking requires us to be very careful in recognizing that equities are not simply a claim on next year’s forward operating earnings, but are instead a claim on the very long-term stream of cash flows that will actually be delivered into the hands of investors over time. With profit margins at record highs, easily 70% above long-term norms, current estimates of forward operating earnings are wholly unrepresentative of those long-term cash flows. As a result, second-order thinking would seem to encourage the question “What is more strongly correlated with actual subsequent market returns? Is it the raw, unadjusted multiple of stock prices to expected earnings, or is it the valuation of stocks after properly adjusting for the predictable cyclicality of profit margins?”

This doesn’t have to be a philosophical question, because a century of evidence can be brought to bear on it. The unequivocal answer is that valuation measures that adjust for margin cyclicality are roughly 90% correlated with subsequent 10-year returns, while unadjusted measures such as forward operating P/Es (FOEs) and the Fed Model have a correlation of about 30%. Square those figures and you obtain the proportion of variation associated with each: cyclically adjusted measures explain about 80% of the variation in subsequent 10-year returns, while FOEs and the Fed Model explain less than 10%. (see Investment, Speculation, Valuation and Tinker Bell for a review of this evidence – a variety of recent charts in my weekly comments such as price/revenue and market cap to GDP also illustrate the tight correspondence of these measures to subsequent returns).

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