John Hussman: Zen Lessons in Market Analysis

Excerpt from the Hussman Funds' Weekly Market Comment (10/11/09):

It is important that we don't place so much emphasis on “average outcomes” that we ignore the facts about particular instances. We still have to look carefully at reality to make sure that we aren't assuming away particular features that are important.

This is a risk that market participants seem to be taking here in a major way. Specifically, we have seen a great number of research reports with the basic thesis of “The recession is over. Here is how the market (or the economy, or employment, etc) has performed after a recession is over.” The difficulty is that these are basically attempts to say “here is an elephant” and then immediately move to describing elephants in general, when in fact, this particular elephant is very likely to be pink, or white. Specifically, valuations here are far different than they have been at the beginning of the typical economic expansion. Moreover, economic expansions have historically always been paced by rapid expansion in debt-financed classes of expenditure such as housing, capital spending, and sustained (not just one-off cash for clunkers) demand for automobiles. In prior recoveries, debt-financed expenditures have turned up quickly and have typically led other classes of expenditure by nearly a year.

If we want to see things as they truly are, we have to look both at the elephant, and at anything that might set this particular elephant apart. With regard to the investment markets, if we suspect that the particular features of the present situation make things “different” than they have been historically, then it is best to look closely and get more data.

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Presently, my primary concern is that stocks are now overvalued, to about the same extent as they were in the late 1960's, and just prior to the 1987 crash, but certainly less overvalued than they were at the 2000 or 2007 peaks. Our 10-year total return projection for the S&P 500 is centered modestly above 6% annually, even if one assumes that the long-term path of earnings has been unchanged by the events of recent years. If we assume that the economy will require a much longer period to recover than has been typical of post-war recessions, the prospects for long-term returns are lower, but we don't need to assume this in order to be concerned about valuation here. (The green, orange, yellow and red lines imply terminal price/peak earnings multiples of 20, 14, 11 and 7 a decade from now. The dark blue line charts actual annual total returns over the subsequent decade).

Though rich valuations and a fresh overbought condition last week argue for tepid returns going forward, my expectation is that strong downward pressure would be most likely if market internals deteriorate somewhat – particularly in terms of breadth. Again, if technical investors are prompted to sell in an environment where sponsorship from fundamental investors is weak, large price changes may be required to relieve the disequilibrium.