Monday, April 23, 2012

Hussman Ringing the Alarm Bell

We currently estimate the prospective 10-year total return on the S&P 500 at about 4.5% annually, in nominal terms, based on our standard valuation methodology. This may not seem bad, relative to 2% yields on the 10-year Treasury bond, provided that investors actually consider either figure to be an adequate 10-year investment return, and provided that they view 4.5% annual returns as adequate compensation for securities that have several times the volatility of a 10-year Treasury bond (especially when yields are low), and provided that investors ignore the fact that prospective market returns tend to enjoy a significant range over the course of the market cycle, so that "locking in" present prospective returns must necessarily forego any higher prospective return that might be observed in the coming decade. Even given robust growth in GDP and corporate revenues, a move to prospective returns of just 6% at some point in the next two years would likely leave investors with no return (including dividends) in the interim (see Too Little to Lock In).
Wall Street continues to focus on the idea that stocks are "cheap" on the basis of forward price/earnings multiples. I can't emphasize enough how badly standard P/E metrics are being distorted by record (but reliably cyclical) profit margins, which remain about 50-70% above historical norms. Our attention to profit margins and the use of normalized valuation measures is nothing new, nor is our view that record profit margins have corrupted many widely-followed valuation measures. As I noted in our September 8, 2008 comment Deja Vu (Again), which happened to be a week before Lehman failed and the market collapsed, "Currently, the S&P 500 is trading at about 15 times prior peak earnings, but that multiple is somewhat misleading because those prior peak earnings reflected extremely elevated profit margins on a historical basis. On normalized profit margins, the market's current valuation remains well above the level established at any prior bear market low, including 2002 (in fact, it is closer to levels established at most historical bull market peaks). Based on our standard methodology, the S&P 500 Index is priced to achieve expected total returns over the coming decade in the range of 4-6% annually." Present valuations are of course more elevated today than they were before that plunge.
Suffice it to say that every P/E multiple is simply a shorthand for proper discounted cash-flow methods, because there are countless assumptions about growth, margins, return on invested capital and other factors quietly baked inside. Like price-to-forward operating earnings multiples, even our old price-to-peak earnings metric has been rendered misleading due to historically high profit margins. Of course, we knew that was happening even before the credit crisis began, and believe that numerous widely-followed valuation measures remain distorted by record profit margins here.
On the economic front, the recent uptick in new unemployment claims is consistent with the leading economic measures and "unobserved components" estimates that we obtain from the broad economic data here (see the note on extracting economic signals in Do I Feel Lucky?). Indeed, it will be difficult to get the expected flat or negative April employment print if weekly new claims don't rise toward about 400,000 in the next few weeks. We've seen "surprising" weakness in some of the more recent regional surveys such as Empire Manufacturing and Philly Fed. A continuation of that trend would also be informative.
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