John Hussman: Release The Kraken

by: John Hussman

Excerpt from the Hussman Funds' Weekly Market Comment (4/30/12):

The problem for the stock market is that the 13-year journey of underperforming T-bills - with wicked collapses and break-even recoveries - is most probably not over. Stocks remain overvalued on the basis of the probable long-term stream of cash flows they will deliver to investors, though the extent of this overvaluation is obscured by unusually high (but reliably mean-reverting) profit margins, which make current and forward P/E ratios seem pleasantly digestible.

There are two ways to think about this. One is to think of these rich valuations and low prospective returns as a durable feature of the market environment. That's basically the vision that PIMCO's Bill Gross recently suggested, noting that we have entered a period of "negative real interest rates and narrow credit and equity risk premiums; a state of financial repression as it has come to be known, that promises to be with us for years to come." His take is well worth the read. That said, an alternate possibility is that we will see a more rapid adjustment as investors lose the apathetic overconfidence that they can ignore the risks of a global economic downturn, massive and recurrent sovereign debt crises, and an implosion of the European banking system. In that event, we are likely to observe a significant increase in risk premiums toward more historically normal levels, but followed by a more gradual recovery in risk assets than the one that followed the 2008-2009 crisis.

My impression is that the Kraken is about to break loose, as valuations are rich and dependent on permanently high profit margins, speculators appear "all in" based on depressed bearish sentiment, mutual fund managers have whittled their cash holdings to nearly zero and have taken on unusually high beta risk, Europe is already in recession, and we are seeing a broad deterioration in U.S. economic data, as coincident evidence catches up with what we've persistently observed in the leading evidence in recent months.


With regard to the elephant in the room, which is Apple, my impression is that what appears to be endless exponential growth is actually the overlay of three separate logistic growth curves - one for the iPod, one for the iPhone, and one for the iPad. These are great products. Still, in order to maintain even a constant level of sales, every unit sold in a given year has to be matched by a replacement the next year - year-after-year - or it has to be matched by a new adoption, and adopters of used products don't count. Simply put, even zero growth demands that every dollar existing users spent on Apple products last year has to be spent again this year, or matched by some new user this year, and then again next year, and again the year after that, ad infinitum. Of course, it's reasonable to expect that late-adopters (e.g. those who have to save in order to afford the product) will have lower replacement rates, which will need to be offset by even greater adoption. Yes, there are billions of people in developing countries without an iPhone. Unfortunately, most of these people are also without running water.

We've seen very rapid adoption rates, very high replacement, and very strong network effects in Apple's products. All of this is an extraordinary achievement that reflects Steve Jobs' genius. I suspect, however, that investors observe the rapid adoption and very high recent replacement rate of three very popular but semi-durable products, and don't recognize how improbable it is to maintain these dynamics indefinitely. Despite great near-term prospects, within a small number of years, Apple will have to maintain an extraordinarily high rate of new adoption if replacement rates wane, simply to avoid becoming a no-growth company. That's not a criticism of Apple, it's just a standard feature of growth companies as their market share expands. It's something that Cisco and Microsoft and every growth juggernaut encounters. Apple is now valued at 4% of U.S. GDP, but then, Cisco and Microsoft were each valued at 6% of GDP at the 2000 bubble peak. Not that things worked out well for investors who paid those valuations. There's always the hope that this time it's different.