Hussman Weekly Market Comment: Run, Don't Walk

Wall Street continues to focus on the idea that stocks are "cheap" on the basis of forward price/earnings multiples. I can't emphasize enough how badly standard P/E metrics are being distorted by record (but reliably cyclical) profit margins, which remain about 50-70% above historical norms. Our attention to profit margins and the use of normalized valuation measures is nothing new, nor is our view that record profit margins have corrupted many widely-followed valuation measures. As I noted in our September 8, 2008 comment Deja Vu (Again), which happened to be a week before Lehman failed and the market collapsed, "Currently, the S&P 500 is trading at about 15 times prior peak earnings, but that multiple is somewhat misleading because those prior peak earnings reflected extremely elevated profit margins on a historical basis. On normalized profit margins, the market's current valuation remains well above the level established at any prior bear market low, including 2002 (in fact, it is closer to levels established at most historical bull market peaks). Based on our standard methodology, the S&P 500 Index is priced to achieve expected total returns over the coming decade in the range of 4-6% annually." Present valuations are of course more elevated today than they were before that plunge.

Suffice it to say that every P/E multiple is simply a shorthand for proper discounted cash-flow methods, because there are countless assumptions about growth, margins, return on invested capital and other factors quietly baked inside. Like price-to-forward operating earnings multiples, even our old price-to-peak earnings metric has been rendered misleading due to historically high profit margins. Of course, we knew that was happening even before the credit crisis began, and believe that numerous widely-followed valuation measures remain distorted by record profit margins here.