John Hussman: Economic Conditions and the Market

by: John Hussman

Excerpt from the Hussman Funds' Weekly Market Comment (8/31/08), which this week is Hussman Funds 2008 Annual Report.

Despite the substantial turbulence that the financial markets have experienced, the U.S. mortgage market still faces a heavy adjustable-rate reset schedule that will continue well into 2010. Meanwhile, despite substantial write-offs and increasing reserve provisions for bad debt held by U.S. banks, the FDIC noted in its recent quarterly banking profile that reserve growth has not kept pace with non-current loans, driving the “coverage ratio” of U.S. banks (loss reserves to non-current loans) to the lowest level in 15 years.

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With regard to the U.S. stock market, corporate earnings have softened considerably, driving the price-to-earnings multiple on the S&P 500 Index well above 20. Unfortunately, the reduced level of earnings for the S&P 500 is at about the level that we would historically expect on the basis of normal longterm profit margins. While price-to-earnings multiples appear much more reasonable on the basis of “forward operating earnings” forecasts from Wall Street analysts, these forecasts do not adjust for the cyclicality of profit margins, and continue to imply a prompt recovery to the record profit margins of recent years.

In my view, it is difficult to escape the fact that S&P 500 earnings, measured from peak-to-peak across market cycles, have been well contained by a long-term growth trendline rising at about 6% annually. This has remained true in recent decades. On that basis, it is straightforward to estimate the range of total returns for the S&P 500 Index that would result from applying a range of future price-to-earnings multiples to mid-channel earnings a decade from now. Multiples between 7 and 20 times earnings describe the vast majority of historical observations. Presently, such a calculation implies probable 10-year total returns on the S&P 500 Index of 3-5% annually, with annual total returns of as high as 9% if one assumes a rich future price-to-earnings multiple of 20 a decade from today (as was observed in 1929, 1972 and 1987), and annual total returns close to zero if one assumes a depressed future multiple of 7 (as was observed at the troughs of 1974 and 1982).

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Investors can draw several implications from current economic conditions. First, given the relatively contained prospects for long-term returns in the stock and bond markets, periodically hedging or reducing market risk is not likely to forgo substantial long-term returns, and may substantially improve long-term returns during periods of market difficulty. I expect that we will probably observe normal or even depressed stock market valuations within the next few years, at which point the benefits of hedging will diminish, and the potential returns from accepting market risk will improve.

In the meantime, a variety of obstacles – including a depressed housing market, rising delinquencies and mortgage foreclosures, a wide U.S. current account deficit, and questionable stability of foreign demand – argue against the expectation of a quick resolution to recent market turbulence. Still, these risks should not be expected to translate into immediate or persistent difficulty for the markets. For that reason, I expect that our investment positions in stocks and bonds will tend to vary between moderate and defensive exposures, rather than maintaining a consistently defensive posture.