Monday, April 21, 2014

Hussman Weekly Market Comment: The Federal Reserve's Two Legged Stool

Extraordinary market returns and dismal market returns both come from somewhere. Long periods of outstanding market returns have their origins in depressed valuations. Long periods of dismal market returns have their origins in elevated valuations. The best way to understand the returns that investors can expect over the long-term is to have a firm understanding of where reliable measures of valuation stand at each point in time. 
A few quick valuation studies may be helpful. As the workhorse for these studies, we'll use the ratio of market capitalization to GDP. Warren Buffett observed in a 2001 Fortune interview that "it is probably the best single measure of where valuations stand at any given moment." 
A variety of normalized earnings measures could be used as well, but emphatically, what should not be used is any price/earnings measure that is not adjusted for the variation of profit margins over the economic cycle. That includes the "Fed Model" and any number of "equity risk premium" measures, which actually have a rather weak correlation with actual subsequent market returns. For more evidence on why margin variation is important to consider, see Margins, Multiples, and the Iron Law of Valuation.