Excerpt from the Hussman Funds' Weekly Market Comment (12/1/08):
One of the features of market panics is that selling tends to be indiscriminate, with only modest regard to the particular features of individual companies or even industries. Over the next few months, investors will begin to pick the wheat from the chaff, and I am hopeful that this will be a particularly good environment for value-conscious investors in individual stocks, even if the general movement of the market is contained within a very wide trading range.
The reason that market panics are indiscriminate is that panic is rarely about long-term cash flows. Market panics are invariably driven by a spike in risk premiums and "index-level" selling of anything liquid. From the standpoint of individual stocks, investing is largely an inference problem where the object is to interpret what portion of a price movement is related to cash flows and what portion represents a change in valuation. This is not a simple problem, particularly because movements in one price are taken as a signal about the prospects for others. In a panic, the market develops a sort of "everything-will-affect-everything" contagion where imaginations run as wild with pessimism as they did with optimism at the top. Contagion allows good companies to become mispriced with the bad ones, and as a bear market proceeds, there is usually a great deal of wheat (consistent cash flows, well-accepted products, strong balance sheets, reasonable valuations, strong return on invested capital) to be picked from the chaff (volatile margins, rapid product obsolescence, weak balance sheets, speculative valuations, poor return on invested capital).
Take S&P 500 earnings back even to the Great Depression and you'll find that despite enormous volatility in year-to-year earnings, the growth rate from peak-to-peak across market cycles has been remarkably steady at about 6% annualized. Cyclical variations in the rate of inflation have had very little effect on this long-term growth rate. Alternatively, you can approach the S&P 500 as the discounted value of a very long-term stream of future dividends (blue), and you'll find that the actual index (red) has reliably traded around that value for over a century. The chart below is based on real dividends and real returns (see Don't Discount Discounted Dividends for details)
The chart above is based on the actual dividends at each point in time, including during the Great Depression. The blue valuation line declines on the basis of this methodology because actual dividends were cut during the Depression, and the model gives full weight to that cut.
As with earnings, however, the stream of income that is realized over time tends to be far better behaved than year-to-year fluctuations might suggest. The value of that stream is particularly well behaved. The chart below shows the price that an investor would have paid for the S&P 500 in order for the actual, realized, subsequent dividends paid on the index to deliver a long-term total return of 10% annually (the current valuation assumes a growth rate of about 6% on normalized dividends from here).
The main lesson of the above charts is that the long-term fundamental value of stocks is far smoother than either prices, earnings or even dividends. The other lesson is that stock prices fell in the late 1920's and over the past year – as well as the past decade – because they deserved to fall.