Tuesday, May 31, 2011

Hussman Weekly Market Comment: Small Windows in an Unfavorable Long-Term Picture

On that note, regardless of how one looks at present market conditions from a cyclical perspective, it is clear that stocks are not in a secular bull market (in the 1950-1965, or 1982-2000 sense). Secular bull markets comprise a whole series of cyclical bull-bear combinations, where each bull market achieves a successively higher level of valuation. Historically, they have started at Shiller-type P/E multiples of about 7 (about 40% below we saw at the 2009 low), and have ultimately ended about 18 years later at multiples above 24, which is, well, about where we are now. That said, I should note that the 2000 peak - at over 40 - was a huge outlier in that regard, with predictably unfortunate consequences for subsequent market returns for a very extended period of time.

The algebra of returns in secular bulls is easy to grasp. Given that S&P 500 earnings have grown at a very consistent peak-to-peak rate of about 6% annually across economic cycles (as have normalized earnings), an 18-year period where the PE moves from 7 to 24 produces overall capital gains of about (1.06)*(24/7)^(1/18)-1 = 13.5% annually. At a Shiller multiple of 7, the dividend yield on the S&P 500 has typically been around 6% or more, while a multiple of 24 puts the yield below 3%, so the average dividend yield over the course of a secular bull has been something over 4%, putting the average total return for the S&P 500 at close to 18% annually over a period of nearly two decades. Since earnings expansion and valuation expansion move in the same direction in a secular bull market, the cyclical bull markets tend to be longer than average, with extended periods of modest, largely sideways returns taking the place of deeper declines, and outright bear markets running somewhat shorter than average.

The algebra of returns in secular bears, in contrast, is predictably hostile. As long as one allows for valuation levels to vary over the long-term, as they have historically, it is very difficult to escape very extended bouts of poor overall returns for stocks once valuations become as elevated as they are today. The canonical 18-year secular bear, again assuming long-term earnings growth is unaffected, produces overall annual capital gains of about (1.06)*(7/24)^(1/18)-1 = roughly zero. In general, dividend income (again, somewhere in the range of 4% over the full course of time) is the primary source of return for passive investors in a secular bear market period. Since the long contraction of valuations offsets the benefits of long-term earnings growth during secular bear periods, the cyclical bull markets tend to be shorter than average, and cyclical bear markets tend to be extended and often brutal.

Despite the "lost decade" since the extreme valuations of 2000, valuations are now presently at about the same level from which prior secular bear markets have just started. There is no basis to expect a secular bull until we observe the valuations from which they have invariably started. Meanwhile, the recent cyclical bull market from the 2009 low has already run the same duration and slightly further than the typical cyclical bull in a secular bear.