Richard H. Serlin

John Hussman: The Stock Market has Never Been this (Intermediate-Term) Overbought

Dr. Hussman,

I am Richard Serlin. I had you for an international finance course in the University of Michigan MBA program in 1997. Thank you for an excellent teaching job.

Perhaps stocks are going to do poorly in the intermediate term, but on your website you write, "For now, my impression is that stocks are not priced to deliver satisfactory long-term returns..."

Robert Shiller's site has the November 2009 P/E 10 at 18.91 which is not bad by historical standards, and that's with earnings unusually depressed by the severe recession. So, why do you think in spite of this that the long term return does not look satisfactory?

John Hussman: Holiday Update

Professor Hussman,

I had you for an MBA international finance class at the University of Michigan in 1996. For the readers, Professor Hussman is an outstanding teacher, and very passionate about teaching.

I have a question, if I may ask, about your April 30, 2007 article, Double Counting. You wrote:

<blockquote><... first problem is that in order to produce 2% real annual growth in earnings per share, companies have historically devoted about 50% or more of their earnings to reinvestment and repurchases - over 300 basis points of that earnings yield to get 200 basis points of real growth. That's a tip-off that historically, competitive pressures have prevented earnings from simply growing at the rate of inflation without new investment. You had to invest new money to get your earnings growth up to the inflation rate.</i></bl...

So the issue is essentially, will just paying depreciation be enough to keep the firm's assets producing the same real income? Certainly the firm's competition moves ahead, and so the firm's capital must too. If you never modernize your computers, software, and other machines, your competitors will steal your business.

But the issue I have here is, while your competitors move ahead, so do your suppliers. Competitive advances appear to be symmetric within the system of corporations. More concretely, depreciation is enough to pay for more than replacement of the company's worn assets, it's enough to pay for improvement of those assets. The old PC cost $2,000, and so did the new one three years later, but the new one was 4 times as fast.

Of course your empirical claim, "that in order to produce 2% real annual growth in earnings per share, companies have historically devoted about 50% or more of their earnings to reinvestment and repurchases - over 300 basis points of that earnings yield to get 200 basis points of real growth.", supports the view that accounting earnings are understating "true firmwide depreciation costs", but the years you measure the data over matter. Jeremy Siegel, using a data series going back to 1802, you quoted in your article as saying, "In the US, the long-term average p/e ratio has been 14.4 times, which corresponds to a 6.9 per cent earnings yield. This is extremely close to the historical average real return on equities." So, he found a good fit in his long empirical data between the standard earnings yield and real returns, indicating that depreciation is enough to both replace capital and improve it enough to keep up with the competition.

What do you think about the counter that depreciation is enough to pay for not just replacement, but improvement of capital, and it therefore may be enough on average to keep competitors from eating away the firm's current profit level? Also, I would be very grateful for any article recommendations to learn more about this, PhD level and non. I'm ABD in finance.