Monday, September 13, 2010

Hussman Weekly Market Comment: Impulse Response

Except for a burst of census hiring that briefly pushed payroll growth above trend during the second quarter of this year, job growth has been perpetually below trend over the past two years. During the post-war period, the civilian labor force has historically grown at about 0.15% each month, which currently implies that normal "trend" job growth should be about 225,000 jobs per month.

While last month's labor report was favorably received by Wall Street, that reception was based strictly on the fact that job losses were not as bad as anticipated, given concerns about a "double dip" in the economy. The problem with this celebration, however, is that analysts continue to overlook the typical lags between deterioration in leading indicators and deterioration in coincident measures, much less lagging ones. As I've noted frequently in recent commentaries, the typical lag between deterioration in say, the ECRI Weekly Leading Index and the ISM Purchasing Managers Index is about 13 weeks, and sometimes longer. The typical lag with respect to new claims for unemployment is about 23-26 weeks (which puts the likely window of deterioration at about the October - November time frame), and the typical lag with respect to the payroll unemployment report is, not surprisingly, about 4 weeks beyond that. The critical risk area here extends for several months, not a few weeks.


The most serious risk

Yet even the near-term risks to employment and the economy are not the greatest risks that investors face. Rather, the most serious risk for investors here is the persistent and misguided eagerness of Wall Street to value long-term assets based on short-term earnings results. Investors have priced the S&P 500 in a manner that is far too dependent on the achievement and maintenance of profit margins about 50% above historical norms. This is a mistake. Profit margins normalize over time, and on the basis of normalized earnings, the S&P 500 is about 40% above robust historical valuation norms (and even further above valuation levels that have represented "generational" buying opportunities such as 1974 and 1982, when well-covered corporate dividend yields averaged about 6.7%, versus the current 2%).

Yes, bond yields are low here, but 10-year bonds are a 7-year duration instrument while U.S. stocks are roughly 50-year duration instruments at present. Wall Street analysts appear very comfortable advising their clients to "lock-in" prospective long-term equity returns for the next 50 years at yields that are dramatically below the norm, simply because 10-year Treasury yields are depressed. But where will the 10-year Treasury yield be in 5 years, in 10, in 15, in 20, in 25, in 30 years? Whatever the yield is today will be a distant memory then, but will the return that investors "locked in" for stocks still look like a value?

For our part, we remain focused on identifying companies with stable revenues, stable profit margins, and a record of distributing cash flows or reinvesting them for growth. We are enormously skeptical of share repurchases and takeovers, which are weak uses of cash with little historical evidence of effective return. If share repurchases were highly counter-cyclical, so that companies massively repurchased stock at depressed valuations and not at elevated ones, we might have more confidence. But that's not what we observe. We prefer companies with stable, predictable cash flows, at reasonable valuations, that earn a consistent return on assets and invested capital, and that don't show earnings with one hand and quietly rob investors of them with the other. These opportunities always exist. In an economy that appears likely to remain difficult, we refuse to value stocks in a way that relies on a resumption of normal economic growth and assumes profit margins 50% above the norm.