Excerpt from the Hussman Funds' Weekly Market Comment (4/21/14):
Nice article this week from someone who knows our work well - Jonathan Laing, the senior editor at Barron’s Magazine. He emphasizes our concerns about valuation and the need to account for the effect of profit margin variation, which can "make stocks seem beguilingly cheap at market peaks," duly observes our miss in this half-cycle (though stress-testing wasn't discussed), “after deftly side-stepping the dotcom- and housing bubble-crashes," and adds "We expect some vindication of his obduracy may lie ahead.” No argument here.
One of the things that some forget is that we shifted to a constructive stance between those two crashes in early 2003, and initially moved toward a constructive stance after the market collapsed in late-2008 (see Why Warren Buffett is Right and Why Nobody Cares) until a parade of policy errors forced us to entertain Depression-era outcomes. My 2009 stress-testing miss and the awkward transition that resulted certainly injured my reputation during this uncompleted half-cycle. Still, having addressed that “two data sets” problem, I expect no similar stress-testing response in future market cycles. Meanwhile, I have every expectation that the current speculative extremes will end in tears for those inclined to dismiss hard, historically reliable evidence by mumbling “permabear.” On the bright side, the conclusion of the present cycle and the course of those that follow are likely to provide strong, extended opportunities to take aggressive investment exposure. Now would just be a particularly inopportune moment to do so.
Extraordinary market returns and dismal market returns both come from somewhere. Long periods of outstanding market returns have their origins in depressed valuations. Long periods of dismal market returns have their origins in elevated valuations. The best way to understand the returns that investors can expect over the long-term is to have a firm understanding of where reliable measures of valuation stand at each point in time.
Quick Valuation Study: 1950
In 1950, the ratio of market capitalization to GDP was at 0.40, while the dividend yield on the S&P 500 was 6.7%. Over the next decade, nominal GDP would grow by about 6.3% annually, and the ratio of market cap to GDP would increase to its (pre-bubble) historical norm of 0.63. As a result, the S&P 500 would go on to post total returns averaging nearly 18% annually over the following decade.
Stay with me here. It’s critical to understand the basic arithmetic behind those outstanding market returns.
The capital gains portion of that annual return was driven by two pieces: the growth in nominal GDP, and the reversion in the ratio of market capitalization to GDP toward its historical norm. Given the numbers above, that piece comes out to:
(1+nominal GDP growth)*(normal MCAP/GDP ratio / actual MCAP/GDP ratio)^(1/10) – 1.0
(1.063)*(0.63/0.40)^(1/10) – 1.0 = 11.2% annually for capital gains
Now add in the 6.7% dividend yield, and you’ve got – not surprisingly – 17.9% annually.
The Federal Reserve’s Two-Legged Stool
“Fundamental to modern thinking on central banking is the idea that monetary policy is more effective when the public better understands and anticipates how the central bank will respond to evolving economic conditions… Recall how this worked during the couple of decades before the crisis. The FOMC's main policy tool, the federal funds rate, was well above zero, leaving ample scope to respond to the modest shocks that buffeted the economy during that period. Many studies confirmed that the appropriate response of policy to those shocks could be described with a fair degree of accuracy by a simple rule linking the federal funds rate to the shortfall or excess of employment and inflation relative to their desired values. The famous Taylor rule provides one such formula.”
- Janet Yellen, FOMC Chair, April 16 2014
In her first public speech on monetary policy, Janet Yellen made it clear that the Fed intends to pursue a more rules-based, less discretionary policy. This is good news. The bad news, however, is that Yellen focused only on employment and inflation. In that same speech, not a single word was said about attending to speculative risks or financial instability (which are inherent in Fed-induced, yield-seeking speculation). Without attending to that third leg, the Fed is resting the fate of the U.S. economy on a two-legged stool.
The problem is this. In viewing the Fed’s mandate as a tradeoff only between inflation and unemployment, Chair Yellen seems to overlook the feature of economic dynamics that has been most punishing for the U.S. economy over the past decade. That feature is repeated malinvestment, yield-seeking speculation, and ultimately financial instability, largely enabled by the Federal Reserve’s own actions.
To overlook yield-seeking speculation as a central element connected to the Federal Reserve’s mandate is to invite a repeat of dismal economic consequences over and over again. The Fed’s mandate need not explicitly refer to financial stability – it is enough to recognize that the failure to take speculation, malinvestment, and financial stability seriously has been one of the primary causes of economic and financial crises that prevent the Fed from achieving that mandate. Indeed, the Fed has again baked such consequences into the cake as a result of its policy of quantitative easing, and an associated lack of appreciation for how equity valuations work (particularly the need to consider valuation multiples and profit margins jointly, whenever one uses earnings-based measures).
Nearly every argument that stocks are not in a “bubble” begin with an appeal to 2000, arguing that present conditions are not nearly as extreme as then, so the word “bubble” cannot be accurately applied. Technically, the word “bubble” also implies certain mathematical features, such as violations of “transversality.” Maybe it’s better to use the phrase “speculative extreme.”
Margins and Multiples in 3D
As I noted last week, valuation multiples based on earnings cannot be taken at face value without correcting for the level of profit margins embedded in those earnings (see Margins, Multiples, and the Iron Law of Valuation). A good way to see the effect of factors that cooperate is to examine their effect in 3D. For example, in the chart below, I’ve simulated 100 random values for X and 100 random values for Y. The level on the Z axis is X+Y. If we look at X versus Z head on, or Y versus Z head on, we observe some relationship, but it’s very imperfect. But if we examine X, Y and Z on a 3D plot, from the perspective of the maximum X and the minimum Y (or vice versa), the combined relationship suddenly becomes obvious. Clearly, the highest level of Z is associated with points where both X and Y are simultaneously elevated.
Likewise, the following chart offers a good perspective of why the Shiller P/E is more useful when the impact of profit margins is considered explicitly. It shows the Shiller P/E and the embedded margin from a 3D perspective (technically, the P/E and margin should be plotted on log scale, but the overall plot is little changed by using standard values). The worst market returns, hands down, follow rich P/E ratios, where the earnings themselves reflect elevated profit margins (as we observe presently). For comparative purposes, the current data point is presented in red, with an associated 10-year total return projection hardly above zero.
Of course, the same analysis can be replicated with a variety of earnings-based methods. The implication is very consistent – price/revenue and market capitalization/GDP are generally more reliable metrics of long-term valuation than earnings-based valuation measures that quietly embed the assumption that profit margins will remain permanently depressed or elevated. That’s certainly not to say that earnings are unimportant, but rather that stocks are a claim on a very, very long-term stream of future cash flows, and year-to-year earnings (and even 10-year smoothed earnings) are often poor indications of that long-term stream.