John Hussman: The Cliff

Includes: DIA, QQQ, SPY
by: John Hussman

Excerpt from the Hussman Funds' Weekly Market Comment (11/15/10):

Last week, the return/risk profiles that we estimate for stocks, bonds and even gold declined abruptly, based on the metrics we track. We don't know how long this shift will persist, but at present, investment risk appears to have spiked considerably, and our estimates of prospective market returns have deteriorated. The abruptness of the shift in market conditions is exemplified by the weakness observed in Irish, Greek and Spanish debt, as well as the plunge in municipal bonds (particularly, as Barry Ritholtz observes, in CA issues - see the chart below), which was steep enough to erase nearly a full year of progress in just three days.

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On the NYSE, hundreds of stocks achieved new 52-week highs, but ended down on the week, with technical evidence suggesting a uniform reversal from a "high pole" buying climax. The percentage of bullish investment advisors reached 48.4% - the highest since the April peak, while the AAII sentiment poll shot to 57.6% bulls - the highest since 2007. Our bond market measures shifted to an unfavorable status for yield pressures, putting the stock market in an overvalued, overbought, overbullish, rising-yields conformation despite QE2, which as anticipated, has been met with fairly eager offers from bondholders.


I've reviewed the valuation conditions of the stock market extensively in recent months, emphasizing that stocks are not a claim on a single year's earnings, but rather on a whole stream of future cash flows that will be delivered to investors over time. At present, investors and analysts who focus on simple price/earnings multiples (rather than modeling the entire stream of cash flows) are placing themselves at tremendous risk, because simple P/E multiples are being distorted by unusually wide profit margins. Part of this can be traced to weak employment conditions, which have held down wages and salaries. But there is more to the story - the rebound in profit margins also reflects a heavy contribution from financials (which may be more indicative of accounting factors than sustainable earnings), as well as the tail-end of stimulus spending.

The chart below underscores the relationship between high current profit margins and poor subsequent earnings growth. The blue line shows U.S. corporate profits as a percentage of GDP (left scale), which is currently just over 8% and at the highest level since 2007. The red line depicts subsequent 5-year growth in profits, but on an inverted right scale (higher values are more negative). In effect, it should not be a surprise if present levels of corporate profits are followed by negative profit growth over the coming 5 years. Indeed, the 2009 burst of stimulus spending is most probably the only factor that has prevented profit growth from being negative over the most recent 5-year period.

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