John Hussman: The Delusion Of Perpetual Motion

Includes: DIA, IWM, QQQ, SPY
by: John Hussman

Excerpt from the Hussman Funds' Weekly Market Comment (6/30/14):

The central thesis among investors at present is that investors have no other choice but to hold stocks, given the alternative of zero short-term interest rates and long-term interest rates well below the level of recent decades (though yields were regularly at or below current levels prior to the 1960s, which didn’t stop equities from being regularly priced to achieve long-term returns well above 10% annually). In this environment, many analysts have argued that elevated stock market valuations are "justified" by the depressed level of interest rates. As I observed the last time around* (see Explaining isn’t Justifying):

“If you examine the full historical record, you'll find that the relationship between S&P 500 earnings yields and 10-year Treasury yields (or other interest rates for that matter) isn't tight at all. The further you look back, the weaker the relationship. To a large extent, the relationship we do observe is linked to the single inflation-disinflation cycle that began in the mid-1960's, hit its peak about 1980, and then gradually reversed course over the next two decades. Still, it's clear that during the past few decades, however one wishes to explain it, earnings yields and interest rates have had a stronger relationship than they have exhibited historically (though not nearly as strong as the Fed Model implies).

“So why isn't it correct to say that lower interest rates justify today's elevated P/E ratios? It's in the meaning of the word ‘justify’ where things get interesting. To most investors, a justified valuation is the level of prices that would still be likely to deliver a reasonable return. Unless that's true, being able to explain the price/earnings ratio is not enough to say that it's a justified valuation. While it's true that lower yields have been associated with higher P/E ratios in recent decades, the meaning of that for investors isn't positive or even neutral, it's decidedly negative. Stocks since 1970 have been heavily sensitive, and possibly overly sensitive, to interest rate swings. While lower interest rates have supported higher P/E ratios, those lower rates and higher P/E ratios, in turn, have been associated with poorer subsequent stock market performance. In short, if investors want to argue that low interest rates help to explain today's elevated P/E ratios, that's fine, as long as they also recognize that subsequent returns on stocks are likely to be dismal in the future as a result.”


Let me say that again. The Federal Reserve’s promise to hold safe interest rates at zero for a very long period of time has not created a perpetual motion machine for stocks. No – it has simply created an environment where investors have felt forced to speculate, to the point where stocks are now also priced to deliver zero total returns for a very long period of time. Put simply, we are already here.

Based on valuation measures most reliably associated with actual subsequent market returns, we presently estimate negative total returns for the S&P 500 on every horizon of 7 years and less, with 10-year nominal total returns averaging just 1.9% annually. I should note that in real-time, the same valuation approach allowed us to identify the 2000 and 2007 extremes, provided latitude for us to shift to a constructive stance near the start of the intervening bull market in 2003, and indicated the shift to undervaluation in late-2008 and 2009 (see Setting the Record Straight).

I should also note that despite challenges since 2009 related to my insistence on stress-testing against Depression-era data, our valuation methods haven’t missed a beat, and we’ve used the same general approach for decades now. Criticize my fiduciary stress-testing inclinations in response to the credit crisis (which we correctly anticipated). Decry the as-yet uncorrected persistence of extreme overvalued, overbought, overbullish syndromes in recent half-cycle, far longer than they have persisted historically. But don’t imagine that these objections will make the total returns of the S&P 500 any better than zero over the coming years. I’m convinced that we’ve addressed the challenges we confronted in the half-cycle since 2009. No doubt, a further diagonal and uncorrected advance would make us no more constructive than we are at present. Still, one might want to review how our approach served us over complete market cycles prior to this speculative episode. We certainly expect that the next 7-10 years will include a separate bull market, or even two. So there will undoubtedly be strong investment opportunities along the way, but not at these prices. My impression from history is that the completion of the present market cycle will begin with a panic, and end with yet another.


A few comments about how interest rates affect equity valuations may be useful. If one views a historically normal Treasury bill yield to be about 4%, it follows that if the Federal Reserve was to surprise the markets with one additional year of zero interest rates, beyond current expectations, that surprise would actually be worth a one-time boost to stock prices of only about 4%. Likewise, if the Fed was to shorten the horizon by one year, it would be worth only a 4% loss. The Bernanke Fed certainly tried to leverage this modest but legitimate effect of interest rate expectations through “forward guidance” that promised zero interest rates for years, and longer than appeared credible except in an economy without growth.

That’s the finance of it, and one can demonstrate it using any discounted cash flow method. If one expects short-term interest rates to be held at zero (instead of say, 4%) for another 5 years, it would be sensible for equity valuations to be about 20% above their long-term norms. Assuming a gradual movement toward normal valuations at the end of that 5-year period, the differential would shave about 4% annually from what would otherwise be normal equity returns over that period. At present, however, one would have to expect another 25 years of zero short-term interest rates in order to justify current valuations (and even that assumes that nominal GDP growth proceeds at about 6% annually in the interim). Stock prices have advanced far more than legitimate interest rate effects can explain, so this is certainly not how investors are thinking about the problem. Instead, they are pricing stocks as if zero-interest rate policy creates some sort of perpetual motion for stocks in and of itself. Given the extremes to which valuations have been driven, investors have now priced stocks to deprive them – for a very long period of time – of any expected return at all.

Stock valuations now reflect not only the absence of any interest-competitive component of expected returns, but the absence of any expected compensation for the greater risk of stocks, which is not insignificant – as investors might remember from 2000-2002 and 2007-2009 plunges, despite aggressive easing by the Federal Reserve throughout both episodes. We expect the compensation for taking equity risk to be negative over the coming 7-year horizon. Market crashes are always and everywhere a reflection of an abrupt upward shift in the risk premiums demanded by investors, and that piece of investor psychology is less under Fed control than investors seem to believe. We expect many years of poor market returns, but we don’t know the precise path the market will take to arrive at nowhere. We aren’t forecasting or relying on a crash, but we certainly have no basis to rule out that possibility – particularly if we observe any upward pressure at all in risk-premiums on corporate and junk debt, or any material breakdown in market internals from here.