Hussman Weekly Market Comment: Overlooking Overvaluation

Presently, on the basis of smooth fundamentals such as revenues, book values, dividends and cyclically-adjusted earnings, the S&P 500 is somewhere between 40-70% above pre-bubble valuation norms, depending on the measure. That’s about the same point they reached at the beginning of the 1965-1982 secular bear period, as well as the 1987 peak. Stocks are far less overvalued than they were in the late-1990’s, but it is worth noting that nearly 14 years of poor market returns have resulted simply from the retreat from those bubble valuations to the current rich valuations. If presently rich valuations were to retreat again to undervalued levels that have accompanied the start of secular bull markets (see 1982 for example), stocks would produce yet another extended period of dismal returns. That prospect certainly isn’t the reason for our present defensiveness, but it’s worth understanding the dynamic that has produced the pattern of market returns we’ve observed over time.

The defining feature of dividends, revenues, book values and the 10-year average of inflation-adjusted earnings (the denominator of the Shiller P/E) is that they are smooth and insensitive to cyclical fluctuations in profit margins over the business cycle. In contrast, standard price/earnings ratios generally seem very reasonable when profit margins are elevated, and seem extreme when profit margins are depressed. Needless to say, that is no small risk for investors who are enamored with seemingly “reasonable” P/E ratios based on forward operating earnings (which assume that companies will indefinitely earn profit margins about 70% above historical norms).

While we prefer to explicitly model the stream of expected future cash flows in our own valuation work, these multiples can be converted into 10-year total return estimates for the S&P 500 using a fairly “model free” rule of thumb, by associating “fair” value with a 10% prospective return. If we write the normalized price-fundamental ratio as “NPF”, and assume that deviations are gradually corrected over a period of 10 years, we have:

Estimated prospective 10-year S&P 500 total return = 1.10/(NPF^.1) – 1

So for example, an NPF of 1.0 corresponds to a 10% 10-year prospective return. An NPF of 0.5, which we might see at the start of a secular bull market, would correspond to a 10-year prospective return estimate of 1.10/(0.5^.1)-1 = 17.9%.

As a more concrete example, with the S&P 500 price/dividend ratio presently about 43, versus a historical norm of 26, the NPF on dividends is about 43/26 = 1.65. That figure translates into a 10-year prospective return estimate of 1.10/(1.65^.1)-1 = 4.6%.