John Hussman: The Line Between Rational Speculation And Market Collapse

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Includes: DIA, IWM, QQQ, SPY
by: John Hussman

Excerpt from the Hussman Funds' Weekly Market Comment (12/29/14):

The Shiller P/E (S&P 500 divided by the 10-year average of inflation-adjusted earnings) is now 27, versus a long-term historical norm of 15 prior to the late-1990’s bubble. Importantly, the profit margin embedded into the Shiller P/E is currently 6.7% versus a historical norm of just 5.4%. The implied margin is simply the denominator of the Shiller P/E divided by current S&P 500 revenues (the ratio of trailing 12-month earnings to revenues is even higher at 8.9%). As I showed in Margins, Multiples and the Iron Law of Valuation, taking this embedded margin into account significantly improves the usefulness and correlation of the Shiller P/E in explaining actual subsequent market returns. With this adjustment, the margin-adjusted Shiller P/E is now nearly 34, easily more than double its historical norm.

This fact is important, because the Shiller P/E averaged 40 during the first 9 months of 2000 as the tech bubble was peaking. But that Shiller P/E was associated with an embedded profit margin of only 5.0%. Adjusting for that embedded margin brings the margin-adjusted Shiller P/E at the 2000 peak to 37.

Quite simply, stocks are a claim not on one or two years of earnings, but on a very long-term stream of cash flows that will actually be delivered into the hands of investors over time. For the S&P 500, that stream has an effective duration of about 50 years. At normal valuations, stocks have a duration of about half that because a larger proportion of the cash flows is delivered up-front.

The point is that our concerns about valuation aren’t based on what profit margins might do over the next several years. To take earnings-based valuation measures at face-value here is essentially a statement that current record-high profit margins, despite being highly cyclical across history, will remain at a permanently high plateau for the next 5 decades. That’s the only way that one can use current earnings as representative of the long-term stream of cash flows that stocks will deliver over time. In order to use a simple P/E multiple to value stocks, this representativeness assumption is an absolute requirement.

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Current equity valuations provide no margin of safety for long-term investors. One might as well be investing on a dare. It may seem preposterous to suggest that equities are literally more than double the level that would provide a historically adequate long-term return, but the same was true in 2000, which is why the S&P 500 experienced negative total returns over the following decade, even by 2010 after it had rebounded nearly 80% from the 2009 lows. Compared with 2000 when we estimated negative 10-year total returns for the S&P 500 even on the most optimistic assumptions, we presently estimate S&P 500 10-year nominal total returns averaging about 1.3% annually over the coming decade. Low interest rates don’t change this expectation – they just make the outlook for a standard investment mix even more dismal – and the case for alternative investments stronger than at any point since 2000. I’ll repeat that if one associates historically “normal” equity returns with Treasury bill yields of about 4%, the promise to hold short-term interest rates at zero for 3-4 years only “justifies” equity valuations 12-16% above historical norms. Again, at more than double those historical norms, current equity valuations provide no margin of safety for long-term investors.

To put some full-cycle perspective around present valuations, understand that 1929 and 2000 are the only historical references to similar extremes. Moreover, aside from the 2000-2002 bear market (which ended at fairly elevated valuations but still allowed us to shift to a constructive outlook in early 2003), no bear market in history – including 2009 – ended with prospective 10-year returns less than 8% (See Ockham’s Razor and the Market Cycle to review the arithmetic of these estimates). This was true even in historical periods when short and long-term interest rates were similar to current levels. Currently, such an improvement in prospective equity returns would require a move to about 1200 on the S&P 500, which we would view as a fairly pedestrian completion of the current market cycle – certainly not an outlier from the standpoint of historical experience.

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The line between rational speculation and market collapse

However – and this is really where the experience of the past few years and our research-based adaptations come into play – there are some conditions that historically appear capable of supporting what might be called “rational speculation” even in a severely overvalued market. Depending on the level of overvaluation, a safety net might be required in any event, and that would certainly be the case if those conditions were to re-emerge here. But following my 2009 insistence on stress-testing our methods against Depression-era data, and the terribly awkward transition that we experienced until we nailed down these distinctions in our present methods, the central lesson is worth repeating:

Neither our stress-testing against Depression-era data, nor the adaptations we’ve made in response extreme yield-seeking speculation, do anything to diminish our conviction that historically reliable valuation measures are of immense importance to investors. Rather, the lessons to be drawn have to do with the criteria that distinguish periods where valuations have little near-term impact from periods where they suddenly matter with a vengeance.

I detailed these lessons in my June 16, 2014 comment – Formula for Market Extremes (see the section entitled Lessons from the Recent Half Cycle). That’s really the point at which we were finally able to put a box around this awkward transition and view it as fully addressed. See also Air Pockets, Free Falls, and Crashes, A Most Important Distinction, and Hard-Won Lessons and the Bird in the Hand.

Historically, the emergence of extremely overvalued, overbought, overbullish conditions has typically been followed by an “unpleasant skew” – a succession of small but persistent marginal new highs, followed by a vertical collapse in which weeks or months of gains are wiped out in a handful of sessions. In prior market cycles, more often than not, periods of extremely overextended conditions were also already accompanied by a subtle deterioration in market internals or widening credit spreads.

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Unpleasant skew

From a near-term perspective, my impression is that recent market action is very much in line with the “unpleasant skew” that one would expect from present conditions. On that basis, we should fully expect a tendency toward small but persistent marginal new highs – including points where the market retreats somewhat and then spikes back up to a marginally higher level. Absent a material improvement in market internals and credit spreads, however, that tendency is also likely to be accompanied by an abrupt vertical drop that wipes out weeks or months of market gains within a handful of sessions. It would be nice to be able to narrow down the window for that event, but that research question has always been difficult to answer. The best we can say is that going into every session here, the probability of an advance is greater than 50%, but the expected return is significantly negative. Numerous small gains, more than offset by a handful of wicked losses. That’s what I mean by unpleasant skew.

Valuations remain obscene from a historical perspective, bullish sentiment is lopsided (52.5% bulls to 15.8% bears according to Investors Intelligence), and we observe severely overbought conditions at record highs. Moreover, credit spreads have normalized only slightly, and internals have not improved enough to signal a shift from the risk-aversion that emerged a few months ago. Indeed, the day-to-day action of the broad market here looks quite a bit like the topping process that the market experienced in 2007. The chart below shows the peaking process of the New York Stock Exchange Composite Index during 2007. Note the initial selloff as market internals broke down in July of that year. See Market Internals Go Negative for my comments at the time. That initial selloff was followed by a full recovery and a persistent series of marginal new highs, a smaller selloff, and then another push higher before the market eventually rolled into a major collapse.

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It may be imperceptible that we are doing anything differently, or that we have addressed anything at all. It may take even more time for that to become clear. But again, I am convinced that the distinctions and hard-won lessons I've repeatedly articulated in recent months matter, because we can demonstrate their effect across a century of market cycles. Equally important, we don't rely on a collapse or dread a continued bubble. I believe what we need most is patient discipline.

Again, a firming in broad market internals and a return to narrow credit spreads would convey a signal that investors had at least temporarily shifted back to risk-seeking behavior. That wouldn’t ease our concerns about the level of valuations or remove the need for a safety net, but it would defer our concerns about immediate consequences. We’re going to take our evidence as it comes. My hope is that it is clear exactly how and when we addressed the challenges that made the recent half-cycle such a difficult transition. There are useful lessons here that I expect will help investors to avoid outcomes like the market experienced in 2000-2002 and 2007-2009, while still leaning to a constructive investment stance in the majority of market periods when extreme valuations, widening credit spreads, and breakdowns in market internals have typically not been joined as dangerously as they are today.

To look at the past 14 years and draw the lesson that rich valuations can be ignored (even when market internals and credit spreads are deteriorating), that hedging is a fool’s game, and that Fed easing can be relied on to drive stock prices higher, is to forget the principal lessons from the most severe market losses that the equity market has endured throughout history. What repeatedly distinguishes bubbles from the crashes is the pairing of severely overvalued, overbought, overbullish conditions with a subtle but measurable deterioration in market internals or credit spreads that conveys a shift from risk-seeking to risk-aversion.