Sunday, January 26, 2014

Hussman Weekly Market Comment: Increasing Concerns and Systemic Instability

Link to: Increasing Concerns and Systemic Instability
With the S&P 500 just 3% below its all-time high, there’s very little change our views here. Last week’s mild retreat only looks something other than mild when viewed in the context of a late-stage parabolic advance that has not seen a single 2.5% weekly decline since June of 2012. At the typical historical frequency, we would have had eight of them.

The ratio of nonfinancial equity market capitalization to nominal GDP is presently about 120%, compared with a historical average prior to the late-1990’s bubble of just 55%. The comparison - about double the historical norm - is about the same if one uses the Wilshire 5000, which includes financials, and for Tobin’s Q (price to replacement cost of assets). The price/revenue multiple of the S&P 500 is presently 1.6, versus a pre-bubble norm of just 0.8. All of these measures have a correlation of about 90% with subsequent 10-year S&P 500 returns, even including recent bubbles and subsequent busts.

The reason we generally don’t include late-90’s bubble data in the calculation of historical norms (though one should always be explicit about it), is that the S&P 500 has achieved total returns of hardly more than 3% annually for almost 14 years since the 2000 peak as the result of those valuations, and yet the historical extremes remain only partially uncorrected. We currently estimate nominal total returns for the S&P 500 averaging just 2.7% annually over the coming decade - no more than the present yield on 10-year Treasury bonds (though stocks are likely to experience far greater volatility and interim losses). These estimates incorporate a broad variety of fundamentals, including properly normalized forward operating earnings (see Valuing the S&P 500 Using Forward Operating Earnings).

Disagreements between valuation methods can be quickly resolved by examining the data. In every case, measures suggesting stocks as fairly valued or undervalued are those that take current profit margins at face value, and assume that current earnings are a sufficient statistic for corporate profitability over the next five decades (which is roughly the duration over which discounting must occur – see Superstition Ain’t the Way).

There's really no need to focus on the Shiller P/E, as it doesn't particularly underlie our views. But it's broadly followed so I often discuss it as a useful "shorthand" for other valuation measures. As it happens, the Shiller P/E at 25, versus a pre-bubble norm of just 15, is among the more optimistic valuation measures we track (at least those that have reliable historical records). This is because even the Shiller P/E is moderately biased by variations in profit margins. Its explanatory relationship to subsequent returns can be significantly improved by taking that margin variation into account (See the final chart in Does the CAPE Still Work?). Think of it this way. The ratio of Shiller earnings (the 10-year average of inflation adjusted earnings) to S&P 500 current revenues is 6.4% here, versus a historical norm of 5.3%. At normal profit margins, the Shiller P/E would presently be 30 – right in line with other more reliable measures at about double its pre-bubble norm. Even at 25, however, the Shiller P/E exceeds every pre-bubble observation since 1871, except for a few weeks leading up to the 1929 peak.
Increasing our concern is a 10-week average of advisory bulls at 57.7% versus just 14.8% bears – the most lopsided bullish sentiment in decades. Add the record pace of speculation on borrowed money, with NYSE margin debt now at 2.5% of GDP – an amount equivalent to 26% of all commercial and industrial loans in the U.S. banking system. Add the currency collapses in Argentina and Venezuela, as well as fresh credit strains and industrial shortfall in China, and one has any number of factors that could be viewed in hindsight as a “catalyst” (as the German trade gap was viewed after the 1987 crash, in the absence of other observable triggers).

Against all of these concerns is the recognition that the market doesn’t move in a straight line, and that the risks that concern us here have concerned us – though at less extreme levels – too long for many investors to give them much immediate credibility. Immediacy wasn’t really our strong suit in 2000 or 2007 either, but by the time our concerns played out, we still found ourselves far ahead over the complete cycle, with far less pain than speculators endured. Despite the challenges of an unusual but also unfinished half-cycle, and despite our awkward stress-testing transition, I'm comfortable that the tools we've developed and the benefits of discipline will be evident enough over the completion of this cycle and throughout future ones. But as Kierkegaard wrote, “patience is necessary, and one cannot reap immediately where one has sown.”