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Excerpt from the Hussman Funds' Weekly Market Comment (12/15/08):

I continue to view the market as undervalued, but clearly 20% less so than a few weeks ago. Of course, a 20% difference is material. While our investment stance remains modestly constructive on the basis of valuation, we have somewhat less exposure to market fluctuations than we had a couple of weeks ago when prices were extraordinarily compressed. What bothers me about the recent rebound is the tepid volume and general lack of leadership. We certainly don't observe market action from any industry group that reveals investor expectations for an economic recovery. The advance we've seen is better characterized as a short squeeze, and a period where investors have “stepped back” from extreme panic, rather than something that reflects investors “looking across the valley to the eventual recovery.”

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My guess, and it's only a guess, is that the general tenor of the market may remain tepidly positive for a few more weeks, but that we will ultimately observe another frightening leg down in the first part of next year – possibly to re-test the November lows, possibly to new lows, depending on the evolution of economic conditions. The problem isn't that stocks are expensive – they're not. The problem is that the U.S. economy will probably not see the beginnings of a recovery until the second half of 2009, and while we've seen a good deal of fear, the stock market tends to go through a great deal of sideways action after panics like we've observed. It's likely that stocks will trade in a very wide 25-35% range for months. We have to be particularly observant as stocks approach the higher end of that range.

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A number of investors have asked about the potential for bankruptcies to disrupt the long-term assumptions that we make about earnings and cash flows, especially for the S&P 500. The most important observation is again that the past 10-15 years were an anomaly from the perspective of profit margins and return on equity. We will almost certainly see some departure from those extremes, but the “normalized” figures we use have been well below those figures for quite some time. What's really happening now is that the actual figures are reverting to their norms.

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Presently, the price/peak-earnings multiple on the S&P 500 is just over 10, but that is based on peak earnings of about $86 for the Index. If we estimate a conservative level of normalized earnings for the S&P 500 in the range of $65-70, the current level for the S&P 500 would put it at a price-to-normalized earnings multiple of 12.5 to 13.5, which is in the undervalued range, but certainly not near a historical low. A multiple of about 9 times normalized earnings would easily form the base for a powerful multi-year advance in the market, and strong long-term returns. Unfortunately, that multiple would put the S&P 500 at about the 600 level. As I've noted before, I don't expect that we'll observe the 600 level in the current downturn, but we also can't rule it out, and we are very mindful of the potential to “overshoot” to the downside, which has historically occurred even in undervalued markets.

Source: John Hussman: Multiples Come Back to Earth