Monday, May 26, 2014

Hussman Weekly Market Comment: Exit Strategy

Link to: Exit Strategy
The S&P 500 set a marginal new high on Friday, in the context of a broad rollover in momentum thus far this year that we view as likely – though of course not certain – to represent a broad cyclical peak of the sort that we observed in 2000 and 2007, as distinct from spike-peaks like 1987. Valuation measures remain extreme, with the market capitalization of nonfinancial stocks pushing 130% of GDP (relative to a pre-bubble norm of about 55%), the S&P 500 price/revenue ratio at 1.7, versus a pre-bubble norm of 0.8, and the Shiller P/E near 26 – which while lower than the 2000 extreme, exceeds every pre-bubble observation except for a few months approaching the 1929 peak. We presently estimate 10-year nominal total returns for the S&P 500 Index averaging just 2.3% annually, with zero or negative total returns on every horizon shorter than about 7 years.

A side note about valuations and profit margins – my concern about record profit margins here is emphatically not centered on what profit margins may do over the next few quarters or years. The relationship between cyclical movements in earnings and stock prices is simply not very strong. Rather, as I noted in The Coming Retreat in Corporate Earnings, “my present concern is much more secular in nature. It can be expressed very simply: investors are taking current earnings at face value, as if they are representative of long-term flows, at a time when current earnings are more unrepresentative of those flows than at any time in history. The problem is not simply that earnings are likely to retreat deeply over the next few years. Rather, the problem is that investors have embedded the assumption of permanently elevated profit margins into stock prices, leaving the market about 80-100% above levels that would provide investors with historically adequate long-term returns.”

In other words, we should not be concerned about extremely elevated profit margins because earnings are likely to weaken and stock prices might follow over the next couple of years (although that may very well occur). We should be concerned because investors are pricing stocks as a multiple of current earnings. They are implicitly using current earnings as if they are representative and proportional to the entire stream of future earnings going out over the next five decades or more. That’s what it means to use a valuation multiple. It means that you take some fundamental as a sufficient statistic for the stream of cash flows that the security will deliver into the hands of investors for decades to come. If you think you know what wage rates, competitive pressures, interest rates and tax policy will be 10, 20, 30, 40 and 50 years from now, and that the present situation is representative and permanent, good luck with that. Otherwise, investors should recognize that because of the variability of profit margins over the long-term, valuation measures that adjust for variations in profit margins have been dramatically more reliable than unadjusted measures over time (see Margins, Multiples, and the Iron Law of Valuation).