Hussman Weekly Market Comment: The Cliff
Last week, the return/risk profiles that we estimate for stocks, bonds and even gold declined abruptly, based on the metrics we track. We don't know how long this shift will persist, but at present, investment risk appears to have spiked considerably, and our estimates of prospective market returns have deteriorated. The abruptness of the shift in market conditions is exemplified by the weakness observed in Irish, Greek and Spanish debt, as well as the plunge in municipal bonds (particularly, as Barry Ritholtz observes, in CA issues - see the chart below), which was steep enough to erase nearly a full year of progress in just three days.
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Municipal bond investors are clearly re-evaluating the prospects for additional fiscal stimulus from the federal government. Indeed, many state and local governments (as well as health and disability service providers that benefited from stimulus dollars), are beginning to talk about "the cliff" - an abrupt reduction in revenues due to the loss of current stimulus funding which has been used to bridge existing budget shortfalls. My impression is that equity investors face a similar "cliff" which they may not have adequately recognized yet.
The essential point is that stocks are much more richly valued than simplistic P/E multiples would suggest. Investors may pay a heavy price if they fail to adjust valuations for the level of profit margins. The only proper way to value stocks is in relation to measures of sustainable, long-run, full-cycle financial performance.
