Monday, March 7, 2011

Hussman Weekly Market Comment:

Last week, I had the pleasure of speaking to investors at the Ibbotson-Morningstar 2011 investment conference. Since I rarely travel outside of charitable work, it was a nice opportunity to talk with shareholders and other investors. The topic was "Useful Laws and Dangerous Myths of Investing," and I've attached the slides as a PDF, which provide an overall outline.

Nearly a century ago, Charles Dow said "to understand values is to understand the meaning of the market." So I began with what I call The Iron Law of Value: An investment is nothing more than a claim on an expected stream of cash flows that will be delivered to investors over time. Much of that topic is very familiar to readers of these weekly comments - I focused the discussion on the difference between the "fundamentals" that are reported over the short-term (trailing net earnings, forward operating earnings, etc) and the long-term stream of cash flows that is actually delivered to investors, which depends on much broader considerations such as profit margins, sustainability of revenue growth, return on invested capital, the extent to which repurchases simply offset dilution from options grants to insiders, and so forth.

We also talked about simplistic valuation methods such as the Fed Model, which takes the simultaneous decline in 10-year Treasury yields and S&P 500 forward earnings yields from the early 1980's to about 2000, and presumes that there must be a one-to-one correspondence between 10-year yields and S&P 500 earnings yields - which is clearly not supported by longer-term evidence. Likewise, we discussed the uses and drawbacks of "multiples-based" valuation methods (price = fundamental x "fair" price/fundamental ratio) - particularly the large amount of "work" that is quietly required of that "fair" multiple, and the danger of choosing it arbitrarily. As an alternative to those uses of forward operating earnings, I presented our standard methodology, and the historical record of the 10-year total return projections from that model, compared with the actual realized total returns that the S&P 500 subsequently achieved.

Next, I discussed what I call The Iron Law of Equilibrium: Every security that is issued must be held by someone until it is retired.


Link to presentation: Useful Laws and Dangerous Myths of Investing