Reflections on Complacency, Valuations, Bear Market Troughs, Patience
Inquiring minds are reading John Hussman’s article on Overlooking Overvaluation.
Our estimates of prospective stock market return/risk, on a blended horizon from 2-weeks to 18-months, remains among the most negative that we’ve observed in a century of market data.
On the valuation front, Wall Street has been lulled into complacency by record profit margins born of extreme fiscal deficits and depressed savings rates. Profits as a share of GDP are presently about 70% above their historical norm, and profit margins have historically been highly sensitive to cyclical fluctuations. So the seemingly benign ratio of “price to forward operating earnings” is benign only because those forward operating earnings are far out of line with what could reasonably expected on a sustained long-term basis.
On the basis of smooth fundamentals such as revenues, book values, dividends and cyclically-adjusted earnings, the S&P 500 is somewhere between 40-70% above pre-bubble valuation norms, depending on the measure. That’s about the same point they reached at the beginning of the 1965-1982 secular bear period, as well as the 1987 peak. Stocks are far less overvalued than they were in the late-1990’s, but it is worth noting that nearly 14 years of poor market returns have resulted simply from the retreat from those bubble valuations to the current rich valuations. If presently rich valuations were to retreat again to undervalued levels that have accompanied the start of secular bull markets (see 1982 for example), stocks would produce yet another extended period of dismal returns. That prospect certainly isn’t the reason for our present defensiveness, but it’s worth understanding the dynamic that has produced the pattern of market returns we’ve observed over time.
At present, the return of the S&P 500 over the past decade – though below average – has actually overshot what would have been expected in 2002. This reflects the fact that valuations today are still well above their norms. Unless we assume that valuations will remain rich forever, this doesn’t portend well for returns going forward.
We remain convinced that stocks are richly valued here. A fairly run-of-the-mill normalization of valuations in the course of the present market cycle would imply bear market losses of about one-third of the market’s value, without even establishing significant undervaluation. Then again, there’s no assurance that valuations will normalize, or that stocks will experience a bear market here. Maybe Wall Street is correct that profit margins will remain forever elevated and The New Global Economy™ will never again witness “normal” valuations on these measures at all. There’s no shortage of analysts who effectively embrace that view by focusing only on forward-operating earnings.
Not Different This Time
Hussman’s message has been the same for quite some time. I am in the same camp.
For now, the market has other ideas. Yet, to bet on a sustained market advance, one has to believe “It’s different this time”.
I do not believe it will be different this time, although (and as we have seen), market valuations can remain in the stratosphere for lengthy periods of time. However, in such instances the market will eventually take back excess gains as it did in 2000-2001 and again in 2008 through the first quarter of 2009.
Hussman wrote “If presently rich valuations were to retreat again to undervalued levels that have accompanied the start of secular bull markets, stocks would produce yet another extended period of dismal returns.”
I’ve thought about this quite a bit over the past year, and I fail to see a way the stock market does not return to low valuations seen at the end of previous long-term bear markets. Demographics, debt levels, and reversion-to-mean tendencies simply will not support the rosy scenarios of growth most advisors assume.
If so, that means a 10-year P/E at or below 10, possibly for a number of years. The impact for boomers and on pension plans will be stunningly negative.
No Hiding Places
Up to this point, the real loss from stocks could have been compensated by one’s allocation to bonds. However, from this point forward, with the 10-year treasury yield at 1.65% and pension plan assumptions at 8%, it’s highly likely both stocks and bonds will be a drag on a 50/50 portfolio’s real return, and especially on expected (needed) rates-of-return.
This reversion-to-the-mean, slow-growth dynamic, as it unfolds, seems likely to usher in the final exodus from “investing” by the boomers. It will also leave a scar on those in their 20′s and 30′s today, which will keep them out of the markets for some time.
Need For Patience
I honestly believe the only investors, even professionals, who will make it through this exodus intact will be those who are able to hold some real assets and cash, and have the patience to wait, with the ‘patience’ part being the most critical.
There will be plenty of opportunities to buy into the stock market for cyclical rallies, but most investors who try to trade will end up losing money because few have the patience to wait for good opportunities, while others will throw in the towel at precisely the wrong times.
That’s life in a secular bear market, and few understand bear market dynamics. Fewer still actually realize how stacked the odds are against a sustained advance and why that is precisely so.
Mike “Mish” Shedlock