Excerpt from the Hussman Funds' Weekly Market Comment (3/3/2014):
Last week, the S&P 500 closed at a record high. Based on valuation measures that have maintained a nearly 90% correlation with subsequent 10-year total returns (not only historically, but also in more recent decades), we estimate that the S&P 500 is more than 100% above the level at which it would be priced to achieve historically normal returns in the coming years. Another way to say this is that at current prices, we estimate negative total returns for the S&P 500 on horizons of 7-years and less, and nominal total returns for the S&P 500 averaging just 2.4% annually over the coming decade, with historically normal total returns thereafter. Needless to say, a steep intervening retreat in stocks could result in much stronger return prospects much, much sooner than 7-10 years from now.
The accompanying charts bring these estimates up to date. The first presents a broad range of reliable fundamentals versus their historical norms.
The next chart underscores the close relationship between these measures and actual subsequent market returns. The various models include properly estimated dividend income, and are detailed in a variety of prior weekly comments. The Tobin’s Q and revenue model are straightforward variants of the others. Given a prospective 2.4% total return for the S&P 500 over the coming decade (albeit with considerable risk of steep intervening losses), a 10-year bond yield near 2.6%, and the likelihood of depressed short-term interest rates in the foreseeable future, an evenly balanced portfolio of stocks, bonds and cash can be expected to achieve an average nominal total return of only about 2% annually over the coming decade from present valuations. We believe there will be numerous opportunities in the coming quarters and years to commit capital at significantly higher prospective returns and significantly diminished risk of capital loss. Investors, particularly equity investors, are gambling their financial future in a casino where the odds are increasingly against them.
On a valuation basis, stocks are far more overvalued than they were in October 1987, and less overvalued than they were in 2000, but both points warranted a strongly defensive stance because of the syndrome of conditions that emerged. Conversely, stocks were meaningfully overvalued in early 2003 when we shifted to a positive investment outlook, because market action was supportive and historically dangerous features were absent.Valuations alone have little bearing on what investors can expect from stocks over the next several weeks, months, or even quarters.
Profits and national income
Over the years – particularly in 2000, 2007 and again today, we’ve found that one of the hazards of having strongly-held and evidence-driven convictions about valuations, profit margins, and historically extreme conditions is that our work becomes a lightning rod for those who prefer reckless speculation to continue without any reminder that deep losses are increasingly likely. We certainly appreciate informed debate. It's the "Here's a simple reason why all of history suddenly doesn't matter" sort of loose-cannon analysis that gets our eyes rolling.
The latest variant focuses on our view of profit margins. The December 16, 2013 weekly comment, The Coming Retreat in Corporate Earnings details this aspect of our work and the associated data. As I noted then, “My concern at present is emphatically not simply a concern about the near-term direction of earnings, or any assumption that stocks must closely follow earnings. Rather, my present concern is much more secular in nature. It can be expressed very simply: investors are taking current earnings at face value, as if they are representative of long-term flows, at a time when current earnings are more unrepresentative of those flows than at any time in history. The problem is not simply that earnings are likely to retreat deeply over the next few years. Rather, the problem is that investors have embedded the assumption of permanently elevated profit margins into stock prices.”
I’ve noted frequently that after-tax corporate profits as a share of national income are about 70% above historical norms; that these profit shares are heavily mean-reverting and strongly (inversely) associated with subsequent profit growth over the following 3-4 year period; and that the current surplus of corporate profits is the mirror-image of corresponding deficits in household and government savings (a relationship detailed in prior weekly comments). Recent profits data, as well as the entire historical record, are tightly explained by these factors.
What should we make of this unintentional exploration of pre-tax profit shares? An examination of historical movements in corporate profits produces very straightforward conclusions. First, after-tax profits are the basis of competition and arbitrage among corporations over time, and have a strong mean-reverting tendency. As a result, elevated profits as a share of income are predictably followed by sub-par profit growth over the following 4-years or so. Second, taxes act as a “layer” on top of this mean-reverting process, meaning that pre-tax profits also tend to mean-revert, but the level that they revert to shifts over time with the tax burden. It’s certainly not true that a reduction or increase in the tax burden has a permanent effect on the long-term level of after-tax profit margins in a competitive economy.
The bottom line is simple. Corporate after-tax profits as a share of GDP, GNP (or even net national product if one wishes to use that number) are steeply above historical norms. This fact can be fully explained by mirror image deficits in household and government saving - a relationship that can be demonstrated across decades of historical evidence. As a result of a severe credit crisis and a sustained period of lackluster economic activity, we’ve seen a fiscal deficit (elevated transfer payments to households and shortfalls in tax revenue) combined with weak household saving. The combined effect is that companies have been able to maintain revenues while paying a very low share of income to labor and taxes.