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John Hussman, Hussman Funds (189 clicks)
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Excerpt from the Hussman Funds' Weekly Market Comment (2/23/09):

The most recent trailing earnings figure for the S&P 500 was a disaster. The 12-month trailing number is now $28.75, down from $78.60 a year ago. The following chart gives an idea of how far earnings have declined. Note that the recent plunge has taken earnings far below the lower channel line. Bill Hester notes that the trailing 12-month earnings figure for the S&P 500 by the second quarter of this year is estimated to be just $15.

From a long-term perspective, the recent plunge in earnings is likely to be followed by an eventual recovery, so it is important that investors not put too much weight on P/E multiples based on prevailing, depressed earnings. Since the top-channel and bottom-channel earnings lines provide a smooth fundamental that is closely related to long-term (if not short-term) cash flows, these earnings figures offer useful insights into the typical valuation multiples that investors have placed on stocks.

Note that except during the past 15 years or so (a period over which stocks have now returned next to nothing), multiples of even 13 times top-channel earnings were actually quite expensive. Multiples of 20 or more were decidedly reserved for bottom-channel earnings, where a multiple of 25 times bottom-channel would be easily considered to represent rich valuations.

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In contrast, to match the worst historical troughs of market valuations, the S&P 500 would have to decline to between 10 and 11 times bottom-channel earnings, and between 5.5 and 6 times top-channel earnings. That would currently translate to somewhere between 500 and 550 on the S&P 500 Index. These levels are emphatically not forecasts they represent extreme outcomes. Unfortunately, they also cannot be ruled out in the context of a deleveraging cycle plagued by utterly misguided policy responses.

It is essential to understand, however, that at those levels on the S&P 500, stocks would be priced to deliver total returns over the following decade in the likely range of 14-17% annually. The current economic downturn requires us to suspend any optimism that earnings will recover quickly in the coming years, but the iron law of finance that lower valuations imply higher long-term returns is likely to endure, as it did even during the Great Depression.

Source: John Hussman: Lower Valuations Imply Higher Long-Term Returns