A year ago, I noted “investors have become hopeful about ‘green shoots’ of economic recovery. However, nearly all of the improvement has reflected enormous doses of debt-financed government spending, and it is questionable that any of this will translate into sustained private activity. From my perspective, much of the enthusiasm about these green shoots overlooks the extent to which economic recoveries have historically relied on the expansion of private lending and debt creation. Economic expansions are paced not by major growth in consumption (which tends to be fairly smooth even during economic downturns), but instead by gross investment in capital goods, technology and housing, as well as debt-financed durables such as autos. We are in the midst of – and will continue to require – perhaps the largest adjustment in U.S. personal, corporate and government balance sheets that we will see in our lifetimes. This will be a very long process. Most likely the economic outlook is not up, but very widely sideways.”
While debt-financed government spending helped the U.S. economy to achieve three quarters of moderate economic growth, it is notable that growth has been slightly negative when the impact of federal deficit spending is removed. This is the worst performance in the private economy in any of the 50 years preceding the recent crisis. Meanwhile, the volume of outstanding bank credit has continued to collapse. In recent months, a variety of leading indicators of economic activity, such as the ECRI leading index, have moved to negative readings, suggesting that economic growth may have already peaked. At the time of this report, a number of our own measures of recession risk have deteriorated to the point that very modest declines in stock prices and the ISM Purchasing Managers Index would be sufficient to complete a set of criteria that has always and only been present during or immediately prior to recessions.
A larger concern relates to valuation and long-term return prospects that are likely from current market levels. Measured from peak-to-peak across economic cycles, S&P 500 earnings have rarely exceeded a 6% annual growth rate. While earnings experience a great deal of “cyclical” fluctuation beneath that long-term trend, they can be normalized in a variety of ways to better reflect their long-term dynamics. A decade ago, the valuation of the S&P 500 was well over twice the historical norm, relative to normalized earnings. Despite experiencing a loss over the past decade, the valuation of the S&P 500 is still not at a point, relative to the now higher level of normalized earnings, that has historically resulted in average or above-average long-term returns.
Over more than a century, the pattern displayed by stock market valuations has been broadly characterized by “cyclical” fluctuations typically about 4-5 years in length, each comprising what investors commonly identify as bull and bear markets. However, the larger historical pattern is that the stock market has periodically achieved major extremes of overvaluation and major extremes of undervaluation spaced closer to 17-18 years apart. The deep undervaluation of 1982, and the striking overvaluation of 2000, are examples of these extremes. The long intervening periods between these “secular” extremes generally contain a number of shorter cyclical bull and bear market phases. During periods from a secular trough such as 1982 to a secular peak such as 2000, each successive bull market tends to peak at a higher level of valuation. In contrast, during periods from a secular peak such as the mid-late 1960’s to a secular trough such as 1982, each successive bear market tends to bottom at a lower level of valuation (though not necessarily a lower absolute price level, if earnings and other fundamentals have grown in the interim).
This context is important, because while the market lows we observed in early 2009 appeared extreme relative to the market highs of 2007, the trough was not particularly deep from a long-term valuation perspective. Moreover, the subsequent market advance quickly restored valuations that are, on the metrics we use, among the highest 25% of historical observations. With little basis to expect strong long-term returns from the standpoint of valuations at present, and little basis to expect robust economic growth from the standpoint of credit expansion, it is important to allow for the possibility that investors will require a substantial revision in market valuations in order to accept sustained long-term exposure to market risk.
Without question, there are many Wall Street analysts who presently argue that stocks are cheap. Almost without exception, these assertions are based on 1) using a single year of projected “forward operating earnings” to value the stock market; 2) applying an improperly high “norm” for the price-to-earnings ratio; and 3) ignoring the variation in long-term earnings growth induced by changes in profit margins. To the extent that the usefulness of a valuation model can be judged by its ability to explain subsequent market returns, this valuation debate can be resolved by an examination of historical evidence (see in particular “Valuing the S&P 500 Using Forward Operating Earnings” in the weekly market commentaries of the Hussman Funds website). While the simplistic use of forward operating earnings fails to adequately explain subsequent long-term market returns, it is possible to produce historically accurate 10-year total return projections for the S&P 500 by properly correcting for earnings growth, profit margins and historical valuation norms. Unfortunately, these projections concur with other historically reliable measures in suggesting that the U.S. stock market is substantially overvalued at present.
Still, while valuations and economic considerations may create sufficient headwind to require periodic hedging of market risks, I do expect that we will continue to see a great number of opportunities in individual securities and industries that will provide a basis for investment returns on the basis of security selection. The same difficulties that have prompted what we view as reckless fiscal and monetary policy in recent years is likely, in our view, to provoke inflationary pressures in the second half of this decade, suggesting that securities with returns tied to real assets and commodity exposure may represent opportunity. As credit strains often produce concerns about deflation rather than inflation, my impression is that the next few years will provide adequate opportunities to establish holdings in these areas during occasional periods of price weakness.
Moreover, despite economic challenges, there is every reason for optimism about innovation and discovery in a wide range of areas including wireless communications, medical devices, consumer electronics, genomic medicine, alternative energy, and even creative niche companies within established industries such as apparel and food services. When a company has well-received products that are not easily replicated, has significant opportunity to reinvest earnings into its growing business (rather than repurchasing shares to offset stock-based compensation to insiders), appears capable of delivering a long-term stream of cash flows to its investors over time, and has a stock price that appears reasonable in relation to the present value of those expected cash flows, that company may be a useful component to a well-diversified portfolio. Over the years, the emphasis of the Hussman Funds on careful security selection has been an important factor in our investment returns. I expect that, regardless of overall market prospects, we will observe numerous investment opportunities in securities characterized by favorable valuation and market action.