John Hussman: Optimism Vs. Arithmetic

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

Excerpt from the Hussman Funds' Weekly Market Comment (7/21/14):

Current market conditions provide an ideal moment to highlight the distinction between investment and speculation. Sound investment is a) the purchase of an expected stream of future cash flows that will be delivered to the investor over time, where b) the price paid today will result in an acceptable long-term return if those expected cash flows are delivered, and c) the expectations are set using assumptions that allow a reasonable margin of safety. As Benjamin Graham observed long ago, “Operations for profit should not be based on optimism but on arithmetic.”

Speculation, by contrast, is the purchase of a security in the expectation that its price will increase. Speculation relies much less on calculation than on psychology, particularly of two forms: a) expected changes in sponsorship, and b) expected changes in risk aversion.

Sponsorship essentially reflects a gradual increase in the eagerness of other individuals to participate in an advance (or in the case of a panic decline, to avoid further losses). Note that this does not necessarily require an increase in the number of participants holding the security, since the stock that is purchased by a buyer must – except in the case of new offerings – be supplied by an existing holder who sells. A speculative advance rides on the wave of increasing eagerness of others to hold the security, who in turn expect even further price increases and even greater eagerness by others. The pool of potential sponsors is very deep when bearish sentiment is very heavy and bullish opinion is scarce. The pool of potential sponsors begins to tap out at the point that bullish sentiment becomes very lopsided compared with bearish sentiment, especially for an extended period of time.


Last week’s comment, Ockham’s Razor and the Market Cycle reviews the arithmetic relating to present stock market valuations, and what it means for investors. A century of evidence provides every reason to expect zero total returns on the S&P 500 at horizons of 8 years or less, and only about 1.8% annually over the coming decade. The implications are worse for measures that take the position of profit margins into consideration (which the most historically reliable measures do). I should emphasize that while these measures provided accurate warning at the 2000 and 2007 peaks, they were also quite positive at the 2009 lows, projecting 10-year S&P 500 total returns in the 12-14% annual range, depending on which measure one used (see also our late-October 2008 comment, Why Warren Buffett is Right and Why Nobody Cares).

I’ll note again that our own challenges in the recent market cycle related first to my insistence on stress-testing against Depression era data even though we got the credit crisis quite right, and later, to the unusual persistence of extremely overvalued, overbought, overbullish conditions that have remained uncorrected longer than has historically been the case (see Setting the Record Straight and This Time is Different, Yet with the Same Ending for a review of that narrative, and the adaptations that resulted). It’s quite possible that these conditions will remain uncorrected even longer, and a reliance on that possibility may provide some support to the speculative case. But it’s important not to confuse this speculation with sound investment. Market participants are not investing at current valuations. They are gambling at a point where the untapped pool of potential sponsors and the room for further contraction in risk premiums have become quite limited.

Do interest rates matter? Sure. The rate of return on safe investments can certainly affect the rate of return that investors are willing to accept. Still, we can determine their impact with basic arithmetic – there's no need to guess. As an example, suppose that a “normal” long-term return on U.S. equities is 10%, a “normal” yield on 10-year bonds is 6% (we’ll assume zero-coupons for simplicity), and a “normal” yield on safe Treasury bills is 4%. If interest rates on Treasury bills were expected to be held at zero for a 5-year period, with normal yields thereafter, it would be competitive for stocks and bonds to be priced to achieve commensurately lower returns in the initial 5-year period as well. This means raising prices accordingly. If you do the arithmetic, you’ll find that the “fair” price of stocks and bonds in this case would be roughly 20% higher than you would calculate otherwise (e.g. for bonds 100/(1.02)^5*(1.06)^5 = 67.68, versus 100/(1.06)^10 = 55.84). Importantly, while one could say that “fair value” was higher, those higher prices would still be associated with lower long-term returns than otherwise.


In other words, one can certainly argue that stocks should be priced for decades and decades of lower long-term returns than they have historically enjoyed. But along with that assumption, one must rely on stock valuations never touching historical norms (much less secular troughs) in the interim in order to avoid quite a long period of zero or negative returns from current levels. I’ll reiterate that while secular bear market lows do not occur frequently, they do tend to average about 50% of typical valuation norms (compared with current valuations, which are about 210% of the historical norm, using an average of numerous historically reliable measures). The resulting arithmetic is quite simple: even if stocks were to touch a secular low even 24 years from today, and even if fundamentals such as nominal GDP, corporate revenues, and corporate earnings match their long-term peak-to-peak growth rate of 6% annually between now and then, the S&P 500 would actually be below its current level 24 years from now [Calculation: (1.06^24)*(0.5/2.10) = 0.96].

To repeat Benjamin Graham, possibly before it is too late for investors with horizons shorter than 8-25 years: “Operations for profit should not be based on optimism but on arithmetic.”