John Hussman: A Mixed Bag of Market Conditions

Excerpt from the Hussman Funds' Weekly Market Comment (1/21/08):

A market that is becoming less reckless is typically our friend. Last week, the stock market began to more seriously price in the risk of an oncoming recession, stocks representing reasonable value generally held up well, and some of the air came out of materials stocks and industrial cyclicals. International markets were hammered on Monday, with the U.S. market closed. The hardest hit sectors globally were financials, basic resources and cyclical stocks, so there may be more difficulty for similar U.S. stocks this week. A few of the perplexingly overvalued fertilizer stocks I mentioned last week have already plunged by about 30% in just four sessions, which isn't to say that investors won't drive them back up, but at least some of the speculative pillars are actually showing some faults. If there's any hope for the Fed to do a large “inter-meeting cut,” if only to put the brakes on investor panic, it will be Tuesday morning.

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... market conditions remain unfavorable overall. Valuations have come down, but remain well above historical norms (and significantly above levels that have typically marked the final trough of bear markets). The extent to which valuations look more reasonable depends on the measure one uses. On the basis of the highest level of S&P 500 earnings achieved to-date, the P/E ratio of the S&P 500 is now 15.6, which is not far from the level we observed at the 2002 low... In contrast to accepting the recent level of profit margins as sustainable (as the price/peak multiple does to some extent), we can instead consider where the P/E of the S&P 500 would be if profit margins were fixed at their historical norms. In the graph below, that valuation is represented by the red line: the price/sales multiple...

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Given my view that the U.S. economy has probably entered a recession, it appears fairly unlikely that the full decline in the S&P 500 will ultimately fall short of a minimal bear market decline of say, 20%... That leaves us with a mixed bag of market conditions: major short-term compression that has a strong historical tendency to produce sharp clearing rallies, a likely recession underway that would set a 20% decline to about S&P 1260 as a likely first expectation, and gradually improving valuations that will ultimately translate into better prospects for long-term returns.