Monday, May 16, 2011

Hussman Weekly Market Comment: Hanging Around, Hoping to Get Lucky

Last week, the renowned value investor Jeremy Grantham threw his own hat into the defensive camp (see Grantham's quarterly letter). In truth, he's been there for a while on the valuation front, but proved more nimble than us in conceding the influence of QE2 - "a kind of underlining of the seemingly eternal promise of a bailout should something go wrong, as if Noah had been sent not just one rainbow but two!" Grantham described his willingness to suspend some concerns about valuation as an "experiment in going with the flow," but added that this was personal, and "emphasized the caveat that more serious, risk-averse, long-term investors would not want to play fast and loose with a market then worth only 900 on the S&P. I also added that GMO played pretty strictly by the value book for our clients, shading only a little here and a little there."

Grantham presently estimates fair value at "about 920 on the S&P 500," and warns "the environment has simply become too risky to justify prudent investors hanging around, hoping to get lucky." Now, since it is easy to show that the long-term peak-to-peak trend of S&P 500 earnings and other fundamentals has advanced at an annual growth rate of roughly 6% annually nearly as far back in history as you care to look, a 920 fair value today, coupled with a roughly 2% dividend yield and a current S&P 500 of 1340, works out to an implied total return over the coming decade of [(1.06)(920/1340)^(1/10) + .02 - 1 =] 4% annually. In my view, that's right in the ballpark.

Of course, that 6% underlying peak-to-peak growth would still have to come from somewhere. Part of it, in my expectation, will come from real GDP growth that will be about a half percentage point faster than the 2.5% expected growth in "potential GDP," as I expect the current "output gap" to gradually close over the coming decade. The remainder is likely to come from inflation. But be careful - it is tempting to assume that if inflation comes in higher (as seems likely in the back half of the decade), the long-term return on stocks will also be commensurately higher, but that is the inflation-hedger's first mistake. While stocks have been a fine long-term inflation hedge, they tend to perform miserably (particularly in inflation-adjusted terms) during periods where inflation is rising - particularly if the rising inflation is unanticipated. It's only when inflation expectations are well recognized that stocks finally become priced to compensate accordingly, and of course, they typically do swimmingly when high expectations of inflation prove to be unfounded and inflation rates decline persistently, as we saw in the years following the 1982 market low.