Hussman Weekly Market Comment: Margins, Multiples, and the Iron Law of Valuation
The equity market remains valued at nearly double its
historical norms on reliable measures
of valuation (though numerous unreliable
alternatives can be sought if one seeks comfort rather than reliability). The
same measures that indicated that the S&P 500 was priced in 2009 to achieve
10-14% annual total returns over the next decade presently indicate estimated
10-year nominal total returns of only about 2.7% annually. That’s up from about
2.3% annually last week, which is about the impact that a 4% market decline
would be expected to have on 10-year expected returns. I should note that
sentiment remains wildly bullish (55% bulls to 19% bears, record margin debt,
heavy IPO issuance, record “covenant lite” debt issuance), and fear as measured
by option volatilities is still quite contained, but “tail risk” as measured by
option skew remains elevated. In all, the recent pullback is nowhere near the
scale that should be considered material. What’s material is the extent of present market overvaluation,
and the continuing breakdown in market internals we’re observing. Remember –
most market tops are not a moment but a process. Plunges and spikes of several
percent in either direction are typically forgettable and irrelevant in the context
of the fluctuations that occur over the complete cycle.
The Iron Law of Valuation is that every security is a claim
on an expected stream of future cash flows, and given that expected stream of
future cash flows, the current price
of the security moves opposite to the expected
future return on that security. Particularly at market peaks, investors
seem to believe that regardless of the extent of the preceding advance, future
returns remain entirely unaffected. The repeated eagerness of investors to
extrapolate returns and ignore the Iron Law of Valuation has been the source of
the deepest losses in history.
A corollary to the Iron Law of Valuation is that one can
only reliably use a “price/X” multiple to value stocks if “X” is a sufficient statistic for the very
long-term stream of cash flows that stocks are likely to deliver into the hands
of investors for decades to come. Not just next year, not just 10 years from
now, but as long as the security is likely to exist. Now, X doesn’t have to be equal to those long-term cash flows –
only proportional to them over time
(every constant-growth rate valuation model relies on that quality). If X is a
sufficient statistic for the stream of future cash flows, then the price/X
ratio becomes informative about future
returns. A good way to test a valuation measure is to check whether variations
in the price/X multiple are closely related to actual subsequent returns in the security over a horizon of 7-10
years.
