Long Term Fundamental Value of Stocks Smoother Than Prices

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.

Comments

[jepittman:]

For those who are looking for reasons why it is NOT 'different this time' Hussman has had more consistently good reasoning than anyone I have read on these boards. If you want an education on the markets go to his website and read his archived comments. There are none better.

2008 Dec 01 05:44 PM

[sheople:]

Without going to (still wallowing in my ignorance) his website, I would contend that never before has our nation faced such debt. During the Great Depression, the dollar was still worth money. We could very well be using the money that is being printed as I write this, to burn to keep warm. I don't see that anywhere on the charts. Long live the Federal Reserve.

2008 Dec 01 06:00 PM

[dshort:]

Thanks, John. You get a similar perspective by simply drawing a regression through the data:

dshort.com/charts/SP-C...

Over long time frames, regression to the mean is inevitable. Fortunately, on an inflation-adjusted basis, the overpricing of the U.S. market is less grim than the nominal price would suggest:

dshort.com/charts/SP-C...

Still, regression to the mean after wide variance usually means overshooting on the other side.

Cheers,
Doug

2008 Dec 01 06:27 PM

[Jolly_Rancher:]

Sheople,

I appreciate your comment and share it. But I am beginning to see things a little differently. I am coming around to the idea that, though our country (the USA) is in deep trouble with no end in site, our corporations are not in nearly that kind of trouble. Corporate balance sheets are quite good. The "stock market" does not equal the USA. Further, the global market place does not depend totally on the USA. US companies that can export or move sales abroad will do well over the next 25 years. Companies that depend soley on US sales of low margin products will suffer. I'm not saying this is the bottom of this bear market. But buying big name exporters from this point will pay off. Over the next few years, look for many US corporations to recharter in foreign countries to avoid paying huge taxes. Right now Exxon pays more taxes than all US citizens combined. That can't continue.

Have a great evening.
Jolly Rancher


On Dec 01 06:00 PM sheople wrote:

> Without going to (still wallowing in my ignorance) his website, I
> would contend that never before has our nation faced such debt.
> During the Great Depression, the dollar was still worth money. We
> could very well be using the money that is being printed as I write
> this, to burn to keep warm. I don't see that anywhere on the charts.
> Long live the Federal Reserve.

2008 Dec 01 06:31 PM

[sheople:]

A point well made, Jolly Rancher, & a good evening to you. Think I'll go spend some time with my wife.

2008 Dec 01 07:00 PM

[Glen Bradford:]

"We've got a tug-of-war of war going on," said Al Goldman, chief market strategist at Wachovia Securities in St. Louis. "On one side there's the prospect of several more months of bad economic news and on the other side there's lots of stimulus already on the table."

2008 Dec 01 07:48 PM

[Michael Zhuang:]

Yale Professor Robert Shiller in his 1982 paper found stock price volatility is not justified by subsequent changes in dividends.

www.david-swensen.com/.../

2008 Dec 01 08:15 PM

[DavyJ:]

Jolly Rancher

Oops!

You said "Right now Exxon pays more taxes than all US citizens combined. That can't continue."

For the record, Exxon paid $29.864,000 in taxes for 2007.

Individual taxpayers paid $1,335,441,437.

In fact the total for all corporations was only $395,535,825.

www.irs.gov/pub/irs-so...

Too much talk radio, I suppose.

2008 Dec 01 08:52 PM

[dinky229:]

Where did you find Exxon's tax contribution?


On Dec 01 08:52 PM DavyJ wrote:

> Jolly Rancher
>
> Oops!
>
> You said "Right now Exxon pays more taxes than all US citizens combined.
> That can't continue."
>
> For the record, Exxon paid $29.864,000 in taxes for 2007.
>
> Individual taxpayers paid $1,335,441,437.
>
> In fact the total for all corporations was only $395,535,825. <br/>
>
> www.irs.gov/pub/irs-so...
>
> Too much talk radio, I suppose.

2008 Dec 01 11:27 PM

[pm577:]

I hope you are right. However, with the total collapse of the junk bond market, I have a feeling that many U.S. corporations will begin to fail early next year. It seems like much of the really bad news has been shifted until later.
So far, there has been a failure to contain a 'small' subprime crisis. Then there was a failure in containing a few mortgage lenders from failing. Then there was a failure to contain major banks from failing. A failure to prevent the collapse of the free credit markets.... There is no way all this will somehow not affect regular U.S. Corporations, whose profits are dependent on a stream of regular and affordable financing from a system that is no more.


On Dec 01 06:31 PM Jolly_Rancher wrote:

> Sheople,
>
> our corporations are not in nearly that kind of trouble...
> Jolly Rancher

2008 Dec 01 11:58 PM

[MartynStrong:]

Cap markets are unstable. In the past there was no way to make them stable. But today we have computer power that can be used to make them stable. By using the greater computer power of today we can have a much higher turn over of cap in the cap market. This higher turnover will make the market harder to fix or control and the market will no longer have the unstable run ups or declines. Who can change or control the market when say 20% of the capital is trading each day. So now that we have the compute power to provide for all these transactions that will smooth out the market how to we force people to turn over at a rate of 20% a day? Easy, put a cap gains tax of 0% (zero) on all gains of 7 days or less and put a cap gains tax of 90% of all gains of 7 days or more. The likes of Yahoo Micosoft and/or Sun Micro Systems will give us the systems that will provide automated software agents to support turning over one's investments every 7 days (based on the specs you give the agent). A system like this will make the financial markets work as smoothly as the local fruit market.

2008 Dec 02 03:16 AM

[DavyJ:]

Shortin,

moneycentral.msn.com/i...

2008 Dec 02 08:25 AM

[dc1:]

Send me all the money you were going to burn.

2008 Dec 02 10:39 AM

[fran:]

no combustion[warmth] involved. all computer generated digits. many are but promises to guarantee funding. we'll not know all the truth[results] for several years. pick your poison--

hyperinflation
hyperdeflation
three bears[just right]

hope for the best.


On Dec 01 06:00 PM sheople wrote:

> Without going to (still wallowing in my ignorance) his website, I
> would contend that never before has our nation faced such debt. During
> the Great Depression, the dollar was still worth money. We could
> very well be using the money that is being printed as I write this,
> to burn to keep warm. I don't see that anywhere on the charts. Long
> live the Federal Reserve.

2008 Dec 02 02:52 PM