Monday, October 11, 2010

Hussman Weekly Market Comment: No Margin of Safety, No Room for Error

Over the past 10 years, the S&P 500 has achieved a total return, including dividends, averaging -0.03% annually. Over the past 13 years, the total return for the S&P 500 has averaged just 3.23%. Why have stocks performed so poorly? One word. Valuation. If investors take nothing else from these commentaries, there are two primary lessons that should be clear. First, the poor market returns that investors have achieved for more than a decade were entirely predictable during the late 1990's, based on the historical relationship between valuations and subsequent returns. Second, from current valuations, the similarly poor returns that investors are likely to achieve over the coming 5-7 year period are also predictable based on the same evidence.

While we regularly emphasize that valuation is not particularly useful as a timing tool, we know of no factor with a better record in setting expectations for long-term market returns. We spend a great deal of time discussing market conditions, economic policy, investor sentiment, and other factors in these weekly comments. But it is critical to recognize that these factors simply modify the short-term course that market returns take over periods of perhaps 1-2 years. They do not significantly affect the long-term course of market returns. Once valuations become unusually rich, disappointing long-term returns become baked in the cake.


Citing "imminent funding pressures" in the global banking system, the IMF released a report last week suggesting the potential for a fresh round of bank stress. The primary focus of concern was the European banking system, due to "relatively greater pressure in European banking systems from both sovereign risks and wholesale funding strains," but the IMF indicated that U.S. banks may also need to raise additional capital "to reverse recent deleveraging trends, and possibly to comply with U.S. regulatory reforms." The IMF warned that "Conditions in the global financial system now have the potential of jumping from benign to crisis mode very rapidly."

It will come as no surprise that we agree, but at least for now, investors evidently could not care less. Had investors been correct in ignoring the ultimately disastrous risks of the dot-com bubble, the tech bubble, the housing bubble, and the overleveraging of U.S. financial institutions that preceded the recent credit crisis, we would concede that the market's wisdom on these issues should take precedence over our own concerns. But in our view, those disasters were predictable. Likewise, as noted above, the persistent willingness of investors to misprice stocks is exactly why they have gone nowhere for over a decade. We'd love to be bulls, scampering happily about. But that would be helped if stocks were priced appropriately and if there was not a large anvil suspended on a fraying string overhead.