John Hussman’s latest letter has some very good insights into the state of corporate America. He discusses the idea that corporations are healthier than ever and goes on to show that, while corporations are not unhealthy, they are not nearly the beacons of strength and fiscal prudence that the media might have us believe.
He also discusses an interesting indicator I had never confronted. He calls it the price to net worth ratio. His findings confirm several other valuation metrics which point to an overvalued market and the likelihood of below average historical returns:
Though the Flow of Funds data isn’t as useful as one would like in practice (since it is only reported quarterly with a lag), it turns out that a low ratio of equity market value to total net worth is a very good indicator of high subsequent total returns for the S&P 500 over the following 10-year period. In contrast, a high ratio of equity market value to total net worth is predictably followed by weak 10-year total returns for the S&P 500.
Let’s call this the price-to-net-worth ratio. As of the latest data, the market value of the equities ($15.21 trillion) for non-financial companies was nearly equal to the total net worth of those companies ($15.05 trillion) for a price-to-net-worth ratio of about 1.01. Note that this is NOT fair value – rather, the historical median and average of the price-to-net-worth ratio is just 0.75. The present level of about 1.0 has historically corresponded to a subsequent 10-year S&P 500 total return averaging only about 5% annually, which is fairly close to the estimate we get from a variety of other historically reliable methods, though the recent decline has improved our expectations a bit. Note that the right scale on the following chart is inverted, so higher levels of valuation on the left scale (blue line) correspond to weaker levels of subsequent return on the right scale (red line).
Source: Hussman Funds