John Hussman is highly respected for his prodigious use of data and adherence to what it tells him about the state of the financial markets. His regular weekly market commentary is widely regarded as one of the best-researched, best-articulated publications available to money managers.
John's public appearances are rare, so we're especially grateful he made time to speak with us yesterday about the precarious state in which he sees global markets. Based on historical norms and averages, he calculates that the ZIRP and QE policies of the Fed and other world central banks have led to an overvaluation in the stock market where prices are 2 times higher than they should be:
John Hussman: What's interesting here is that if you think about equities, they're not a claim on next year’s prediction of earnings by Wall Street analysts. A stock, in fact any security, is a claim on any long-term stream of cash flows that investors can expect to be delivered to them over a very long period of time.
When you look at equities you can calculate something called duration. It's essentially the effective life of a security over which you are collecting cash flows in return for the amount you pay. For the S&P 500 the duration is about 50 years. In other words it is a very, very long-term asset. The only reason you would want to price that asset based on your estimate of next year’s earnings is if you were convinced that next year’s earnings are actually representative of the very, very long-term stream — and I'm talking 50 years or so of earnings that you're likely to get — that those earnings are in a sense accurately proportional to the whole long-term stream.
What's amazing about that is that is it has never been true. It has never been true historically. If you look at corporate profits and especially corporate profit margins, they're one of the most cyclical and mean-reverting series in economics. Right now, we have corporate profits that are close to about 11% of GDP, but if you look at that series you will find that corporate profits as a share of GDP have always dropped back to about 5.5% or below in every single economic cycle including recent decades, including not only the financial crisis but 2002 and every other economic cycle we have been in.
Right now stocks as a multiple of last year’s expected earnings may look only modestly over valued or modestly richly valued. Really if you look at the measures of valuation that are most correlated to the returns that stocks deliver over time say over seven years or over the next 10 years the S&P 500 in our estimation is about double the level of valuation that would give investors a normal rate of return.
So right now, we've got stocks valued at a point where we estimate the 10 year prospective return on the S&P 500 will be about 1.6 to 1.7% annualized — talking right now with the S&P 500 at 2032 as of today’s close.
Chris Martenson: I guess 1.6 or 7% doesn’t sound bad if you are getting 0% on your risk-free money, I guess. But this says that any move by the Fed to normalize — which means rates have to go up — any move to drain liquidity from the system is going to have its own impact. If we held all things equal, a normalization effort is going to then basically expose that the stock market is roughly overvalued by 100%.
John Hussman: 100%, yes. I actually think the case is a little bit harsher than that; in fact, quite a bit harsher than that.
The idea that well, "1.7% isn’t so bad" or "1.6% isn’t so bad" ignores the fact that really in every market cycle and economic cycle we have had a point where stocks were fairly valued or undervalued.The only cycle in which we didn’t see that was actually the 2002 low where stocks actually ended that decline at an overvalued level on a historical basis. But valuations were still relatively high on a historical basis in 2002. They got slightly undervalued in 2009, but not deeply.
On a historical basis, what's interesting is that if you look at measures of valuation that correct for the level of profit margins, you actually get about a 90% correlation with subsequent 10 year returns. That relationship has held up even over the past several decades. It has held up even over the past 5 years where the expected return that you would have forecasted based on time-tested valuations turned out to be pretty close to what you would have forecasted 10 years earlier.
Right now, like I say, we are looking at stocks that have been pressed to long-term expected returns that are really dismal. But more important than that, in every market cycle that we've seen with the mild exception of 2002, we've seen stocks price revert back to normal rates of return. In order to get to that point from here, we would have to have equities drop by about half.
This is one of the highest-quality and deepest-diving podcasts we've recorded in the 3-year history of our series. Part 1 is publicly available below. Part 2 can be accessed here (enrollment required).
Click the play button below to listen to Part 1 of Chris' interview with John Hussman (26m:29s):
by gordonx