Excerpt from the Hussman Funds' Weekly Market Comment (4/28/14):
'Even a return to median bull market valuations would be brutal for the most popular tech stocks. We’re not even talking about bear market valuations, and we’re making the leap of faith, contrary to the evidence, that the quality of current revenues is as high as those generated during the past decade. To illustrate the probable epilogue to the current bubble, we’ve calculated price targets for some of the glamour techs, based on current revenues per share, multiplied by the median price/revenue ratio over the bull market period 1991-1999.'
Cisco Systems: $18 ¾ (52-week high: $82)
Sun Microsystems: $4 ½ (52-week high: $64)
EMC: $10 (52-week high: $105)
Oracle: $6 7/8 (52-week high: $46)
'Get used to those itty-bitty prices... And hey, we’re being optimistic.'
In the bear market that followed, those “four horsemen” of tech would fall about 50% below the price targets noted above, except for Oracle, which halted its decline about 3/8 of a point above that target.
We’ve taken a great deal of care in recent months to emphasize that price/earnings ratios are terribly unsuitable to gauge valuation (or estimate long-term prospective returns) unless the earnings figure being used is representative and proportional to the very long-term, multi-decade stream of future cash flows that will be made available to investors over time. Unfortunately, profit margins vary dramatically over the course of the normal business cycle, which demands that investors normalize earnings by accounting for the profit margins that are embedded into them at any given time.
It turns out that every popular earnings-based measure (price to trailing earnings, price to forward earnings, Shiller’s cyclically adjusted P/E, market capitalization to corporate profits) can be made significantly more reliable by pairing the P/E multiple with a consideration of the profit margin embedded within. Indeed, if we statistically relate P/E ratios and profit margins (technically their logarithms) to actual subsequent 10-year market returns, we discover that both factors enter the regression with nearly identical coefficients, meaning that the two can be combined without any loss of information (see Margins, Multiples, and the Iron Law of Valuation). Of course, the product of the P/E and profit margin (or the sum of their logarithms) is simply the price/revenue ratio.
Let’s be very clear – earnings are absolutely essential to generate deliverable cash flows for investors. It’s just that profit margins vary too much to use year-to-year earnings (and to some extent, even smoothed 10-year earnings) as a sufficient statistic for those multi-decade cash flows. Revenues turn out to be much better sufficient statistics. When we look across different companies and industries, of course, price/revenue multiples should and do differ quite a bit. Low margin businesses (such as grocery chains) typically trade at very low price/revenue multiples, while high margin businesses can justify higher price/revenue multiples – provided that revenues can be expected to be maintained or expanded for decades, and the business has distinct competitive advantages that protect margins from much erosion or variation over the economic cycle. There are fewer of those latter companies in existence than people think – they’re the ones that Warren Buffett tends to gravitate toward.
The danger comes when investors drive price/revenue multiples to market-wide extremes, across all stocks and industries. At bull market peaks, investors typically fail to recognize cyclically elevated profit margins, assuming that those margins are permanent and that earnings can be taken at face value. If there is one thing that separates our views here from the bulk of Wall Street analysis, it is the historically-informed insistence that investors are mistakenly banking on record-high profit margins to be permanent. For more on this, including evidence that historical profit margin dynamics remain quite on track and have not changed a whit, see The Coming Retreat in Corporate Earnings, and An Open Letter to the FOMC: Recognizing the Valuation Bubble in Equities.
For our part, the condition and uniformity of market internals across a wide range of stocks, industries, and security-types is an important consideration, as are extreme syndromes of overvalued, overbought, overbullish conditions. We’ve certainly observed overvalued, overbought, overbullish features for much longer than is historically typical, though we do believe that the consequences have been deferred rather than avoided. More importantly, the market has lost significant momentum, the stance of monetary policy is shifting to a less recklessly discretionary and more rules-based approach, and we’re observing increasing divergences in market internals. A loss of uniformity in market internals has historically been an important and subtle indication of rising risk aversion among investors.
The worst market outcomes, hands down, occur in those environments where rich valuations are coupled with deterioration in market internals and a shift toward increasing risk aversion. In contrast, the best market outcomes, hands down, occur in those environments where reasonable or depressed valuations are coupled with early improvement in market internals and a shift toward increasing risk tolerance. Though we fully anticipated the 2008 credit crisis and had no qualms about valuation after the market plunged (see Why Warren Buffett is Right and Why Nobody Cares), our greatest challenge in response to the policy errors that followed was the necessity of stress-testing against Depression-era outcomes. That prevented us from accepting opportunities in the recent half-cycle that both our pre-2009 methods and our present methods – had they been available at the time – would have captured (particularly in 2009 and early 2010). But our subjective “miss” should not be a reason for investors to ignore the objective risks over the completion of this cycle – from what is now the richest broad market valuation that investors are likely to observe in their lifetimes, and that is increasingly coupled with divergent market action and deteriorating uniformity.
The likelihood is poor that from current price levels, broad equity investments – even held for nearly a decade – will generate any positive investment return at all. Among the saddest notes I received in the 2000-2002 and 2007-2009 bear markets were from people who had short investment horizons (and were therefore “forced” sellers) and lamented “I wish I had listened.” Whatever market returns we missed in the anticipation of those market declines were easily lost by the market anyway once the bears gained control. Recall that the 2000-2002 decline wiped out the entire total return of the S&P 500 – in excess of Treasury bill returns – all the way back to May 1996. The 2007-2009 decline wiped out the entire total return of the S&P 500 – again in excess of Treasury bill returns – all the way back to June 1995. I doubt that much of the market’s gain since 2009 will be retained by investors over the completion of this cycle. The run-of-the-mill bear market retraces more than half of the preceding bull market gain. Those that begin from rich valuations wipe out far more.
I’ve historically encouraged buy-and-hold investors to maintain their own investment discipline, though with a realistic and historically-informed understanding of prospective return and risk. At present, my concern is that many buy-and-hold investors are unaware of how dismal prospective returns are likely to be from current prices, over every investment horizon of a decade or less. Given the duration of the equity market (which mathematically works out to be roughly the market price/dividend multiple), a passive 100% exposure to equities is appropriate only for investors with a horizon of about 50 years. Passive buy-and-hold investors would be well-advised to scale their equity exposures accordingly, based on their own actual investment horizons. Meanwhile, it seems clear that investors have mentally minimized their concept of potential downside, despite two 50% bear market losses in recent memory that were both accompanied by aggressive Fed easing all the way down.