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The Delusion of Perpetual Motion

July 2, 2014

In the club where all stock market investors meet every morning when they wake up, the room occupied by those who “don’t understand what is going on” is not as crowded as you might expect. I admit I’m not lonesome – I have plenty of fellow “confusees” to talk with – but I am told they are having to add some more space for the growing crowd in the “it’s a bull market and those stupid old bears just don’t get it” section of the club.

This week’s Outside the Box is a selection from two essays written by an old friend of my readers (and my good friend), Dr. John Hussman. His recent work has been rather forceful in pointing out that expectations of total returns from the US market over the next seven to ten years are dismal. That conclusion agrees with work I have done in conjunction with Ed Easterling, with Jeremy Grantham’s posts at GMO, and with the work of Robert Shiller (mentioned below). There are numerous other analysts who approach the market differently, but the general conclusion is this: investors with a five- or ten-year time horizon are going to be very disappointed unless they have some methodology to deal with the risk of a significant market downturn.

It’s fascinating how investors come to forget that markets move in cycles and not in perpetual diagonal lines. As value investor Howard Marks wrote in The Most Important Thing,Rule number one: most things will prove to be cyclical. Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.”

I was writing in 1999 about secular bear markets. I noted then and in 2003 in Bull’s Eye Investing that it typically takes three significant events to end a secular bear market. We have had two so far in this cycle. The opportunities for stock pickers and traders have been phenomenal. Long-term investors, for their part, have certainly been disappointed. If there is one thing that I believe we can truly “know,” it is that long-term future returns are based on the valuations in place when you invest. The relationships between long-term valuations and returns are fundamental in nature. Yes, there are variations in the actual outcomes, but they are rather minor when considered from a long-term perspective.

Let me put it another way as bluntly and forcefully as I can. If you are “long” the market today, without an exit strategy or a hedge position, your long-term returns are at major risk. I totally understand that you have to be in the market to participate in the returns. I am not a perma-bear. There are clearly ways to be involved in this market without blindly assuming that it will be what John Hussman calls a perpetual motion machine.

Without a lot of comment, let’s go straight to John’s work. I’m actually going to take excerpts from his most recent essay first, as I think that is the logical way to approach the material. You can read all of his work at www.hussmanfunds.com.

Have a great week. And if your country is still in the World Cup chase, enjoy it while it lasts. It was a fun ride for the US, but the script seems to be turning out as forecast, with Argentina and Brazil working their way through the ranks. Maybe someone can stop those juggernauts; they don’t look that invincible. The race, we are told, is not always to the swift or strong – but that is the way to bet, whether in markets or in fútbol.

Your thinking about cycles analyst,

John Mauldin, Editor
Outside the Box

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The Delusion of Perpetual Motion

John P. Hussman, Ph.D.
June 30, 2014

“I am definitely concerned. When was [the cyclically adjusted P/E ratio or CAPE] higher than it is now? I can tell you: 1929, 2000 and 2007. Very low interest rates help to explain the high CAPE. That doesn’t mean that the high CAPE isn’t a forecast of bad performance. When I look at interest rates in a forecasting regression with the CAPE, I don’t get much additional benefit from looking at interest rates… We don’t know what it’s going to do. There could be a massive crash, like we saw in 2000 and 2007, the last two times it looked like this. But I don’t know. I think, realistically, stocks should be in someone’s portfolio. Maybe lighten up… One thing though, I don’t know how many people look at plots of the market. If you just look at a plot of one of the major averages in the U.S., you’ll see what look like three peaks – 2000, 2007 and now – it just looks to me like a peak. I’m not saying it is. I would think that there are people thinking – way – it’s gone way up since 2009. It’s likely to turn down again, just like it did the last two times.”

Professor Robert Shiller, June 25, 2014, The Daily Ticker

The central thesis among investors at present is that they have no other choice but to hold stocks, given the alternative of zero short-term interest rates and long-term interest rates well below the level of recent decades (though yields were regularly at or below current levels prior to the 1960s, which didn’t stop equities from being regularly priced to achieve long-term returns well above 10% annually). In this environment, many analysts have argued that elevated stock market valuations are “justified” by the depressed level of interest rates. As I observed the last time around (see Explaining isn’t Justifying):

If you examine the full historical record, you’ll find that the relationship between S&P 500 earnings yields and 10-year Treasury yields (or other interest rates for that matter) isn’t tight at all. The further you look back, the weaker the relationship. To a large extent, the relationship we do observe is linked to the single inflation-disinflation cycle that began in the mid-1960’s, hit its peak about 1980, and then gradually reversed course over the next two decades. Still, it’s clear that during the past few decades, however one wishes to explain it, earnings yields and interest rates have had a stronger relationship than they have exhibited historically (though not nearly as strong as the Fed Model implies).

So why isn’t it correct to say that lower interest rates justify today’s elevated P/E ratios? It’s in the meaning of the word ‘justify’ where things get interesting. To most investors, a justified valuation is the level of prices that would still be likely to deliver a reasonable return. Unless that’s true, being able to explain the price/earnings ratio is not enough to say that it’s a justified valuation. While it’s true that lower yields have been associated with higher P/E ratios in recent decades, the meaning of that for investors isn’t positive or even neutral, it’s decidedly negative. Stocks since 1970 have been heavily sensitive, and possibly overly sensitive, to interest rate swings. While lower interest rates have supported higher P/E ratios, those lower rates and higher P/E ratios, in turn, have been associated with poorer subsequent stock market performance. In short, if investors want to argue that low interest rates help to explain today’s elevated P/E ratios, that’s fine, as long as they also recognize that subsequent returns on stocks are likely to be dismal in the future as a result.

The corollary to the belief that zero interest rates “justify” elevated valuations is that investors seem to believe that as long as interest rates are held near zero, stocks will continue to advance at a positive or even average or above-average rate.

It’s certainly true that from a psychological standpoint, the Federal Reserve has induced the same sort of yield-seeking speculation that drove investors into mortgage securities (in hopes of a “pickup” over depressed Treasury-bill yields), fueled the housing bubble, and resulted in the deepest economic and financial collapse since the Great Depression. This yield-seeking has clearly been a factor in encouraging investors to forget everything they ever learned from finance, history, or even two successive 50% market plunges in little more than a decade.

But the finance of all of this – the relationship between prices, valuations and subsequent investment returns – hasn’t been altered at all. As the price investors pay for a given stream of future cash flows increases, the long-term rate of return that they will achieve on their investment declines. Zero short-term interest rates may “justify” the purchase of stocks at higher valuations so that stocks promise equally dismal future returns. But once stocks reach that point, investors should understand that those dismal future returns will still arrive.

Let me say that again. The Federal Reserve’s promise to hold safe interest rates at zero for a very long period of time has not created a perpetual motion machine for stocks. No – it has simply created an environment where investors have felt forced to speculate, to the point where stocks – despite their dramatically greater risk – are now also priced to deliver zero total returns for a very long period of time. Put simply, we are already here.

Based on valuation measures most reliably associated with actual subsequent market returns, we presently estimate negative total returns for the S&P 500 on every horizon of 7 years and less, with 10-year nominal total returns averaging just 1.9% annually. I should note that in real-time, the same valuation approach allowed us to identify the 2000 and 2007 extremes, provided latitude for us to shift to a constructive stance near the start of the intervening bull market in 2003, and indicated the shift to undervaluation in late 2008 and 2009 (see Setting the Record Straight).

I should also note that despite challenges since 2009 related to my insistence on stress-testing against Depression-era data, our valuation methods haven’t missed a beat, and we’ve used the same general approach for decades now. Criticize my fiduciary stress-testing inclinations in response to the credit crisis (which we correctly anticipated). Decry the as-yet uncorrected persistence of extreme overvalued, overbought, overbullish syndromes in recent half-cycle, far longer than they have persisted historically. But don’t imagine that these objections will make the total returns of the S&P 500 any better than zero over the coming years. I’m convinced that we’ve addressed the challenges we confronted in the half-cycle since 2009. No doubt, a further diagonal and uncorrected advance would make us no more constructive than we are at present. Still, one might want to review how our approach served us over complete market cycles prior to this speculative episode. We certainly expect that the next 7-10 years will include a separate bull market, or even two. So there will undoubtedly be strong investment opportunities along the way, but not at these prices. My impression from history is that the completion of the present market cycle will begin with a panic, and end with yet another.

If we examine data since 1940, the 10-year total return on the S&P 500 has a correlation of about 83% with the CAPE. Including the profit margin embedded in the CAPE as an additional explanatory variable brings this correlation to about 90% (to understand why, see Margins, Multiples, and the Iron Law of Valuation). As Shiller correctly observes, including Treasury bill and 10-year Treasury bond yields as additional variables adds no further explanatory power. Put another way, interest rates do have an impact on the level of valuations, but the resulting valuations are informative – at face value – about the probable level of future market returns.

On a historical basis, the CAPE of over 26 is already quite enough to expect more than a decade of negative real total returns for the S&P 500. Aside from the crashes that followed the 1929, 2000 and 2007 peaks, a very long period of negative real returns also followed the other historical peak in the CAPE near 24 in the mid-1960’s. As noted above, one adjustment to the CAPE that significantly improves its relationship with actual subsequent market returns – as it does for numerous other measures – is to correct for the implied profit margin embedded into the multiple. This is true even though the denominator of the CAPE is based on 10-year averaging. At present, the margin embedded in the Shiller CAPE is more than 20% above the historical average. Adjusting for that embedded profit margin – which, again, produces a historically more reliable indication of actual subsequent S&P 500 total returns – the Shiller CAPE would presently be over 32. That level might make even Professor Shiller question whether stocks should be a material component of portfolios (at least for investors with horizons much shorter than the 50-year average duration of S&P 500 stocks). In any event, even the phrase “lighten up” is problematic for the market if more than a few investors heed that advice.

The ratio of non-financial equity market capitalization to GDP (which has maintained a tight correlation with subsequent 10-year S&P 500 total returns even in recent times) is now about 134%, compared with a pre-bubble norm of 55%. The median price/revenue ratio S&P 500 components easily exceeds, and the average rivals, the levels observed at the 2000 peak. All of this suggests that investors may not appreciate the extent of present overvaluation, lulled once again by the assumption that cyclically-elevated earnings are permanent. Benjamin Graham warned long ago that this assumption is probably the chief source of losses to investors: “The purchasers view the good current earnings as equivalent to ‘earning power’ and assume that prosperity is equivalent to safety.”

Meanwhile, Fed Governor James Bullard observed last week that even the Fed is not inclined to maintain zero interest rate policy indefinitely: “Investors should be listening to the Committee. Of course, you can do what you want.”

Market Peaks Are a Process

John P. Hussman, Ph.D.
June 2, 2014

“Regardless of very short-term market direction, it is urgent for investors to understand where the equity markets are positioned in the context of the full market cycle. While the most extreme overvalued, overbought, overbullish, rising-yield syndrome we define has generally appeared only at the most wicked market peaks in history, investors have ignored those conditions over the past year. We can’t be certain when the deferred consequences will emerge. But a century of market history provides strong reason to believe that any intervening gains will be wiped out in spades.

“It’s instructive that the 2000-2002 decline wiped out the entire total return of the S&P 500 – in excess of Treasury bills – all the way back to May 1996, while the 2007-2009 decline wiped out the entire excess return of the S&P 500 all the way back to June 1995. Overconfidence and overvaluation always extract a terrible payback.

“It may also be helpful to remember that market peaks are a process, not an event. In the presence of a broad range of reliable valuation metrics uniformly at more than twice their historical norms, coupled with the most severe overvalued, overbought, overbullish, rising-yield syndrome we define, it is instructive how shorter-term action has evolved near those points. Outside of today and 1929, the other two instances are, not surprisingly, 2000 and 2007. The chart below provides a more granular reminder that market peaks are often a broad process and can involve hard initial downturns and swift recoveries. The ultimate follow-through provides some insight regarding the full scale of our concerns.”

It is Informed Optimism To Wait for the Rain – Hussman Weekly Market Comment 3/10/14

I should emphasize that the circled areas on the chart above aren’t chosen arbitrarily but reflect points where similar overvalued, overbought, overbullish extremes were observed. As I’ve noted in recent weeks (see The Journeys of Sisyphus and Exit Strategy), depending on how tightly we define this syndrome the 1972 and 1987 peaks can also be captured among the set of extremes that include 1929, 2000, 2007 and today. Remember that at a fine resolution, the full syndrome sometimes doesn’t precisely align with the final market high. Still, we remain convinced that any near term continuation we observe in this advance is likely to appear quite insignificant in the context of what the market loses over the completion of the cycle.

It’s fascinating how investors come to forget that markets move in cycles and not perpetual diagonal lines. As value investor Howard Marks wrote in The Most Important Thing, “Rule number one: most things will prove to be cyclical. Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.” A normal, run-of-the mill cyclical bear market wipes out more than half of the preceding bull market advance. We should not be surprised at all to see the S&P 500 back at 2010 levels or below over the completion of the present cycle. From a valuation standpoint, we estimate that the S&P 500 Index would have to fall to the 1000 level to bring prospective 10-year nominal total returns toward their historical norm of about 10% annually. With the exception of the 2000-2002 bear market, valuations have typically been lower, and prospective returns higher, at cyclical troughs throughout recorded history (even in data prior to the 1960’s when interest rates were similarly depressed).  Not that we need to forecast such an outcome, and certainly not that we would require anything near historical valuation norms to encourage a constructive stance, provided support from other factors. As always, the strongest prospective market return/risk profile is associated with a material retreat in valuations followed by an early improvement in broad measures of market internals….

Discuss This


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Ronald Nimmo

July 12, 2014, 3:57 a.m.

Mr. Hussman at some point will be proven correct: This cyclical bull will make a top and descend into a cyclical bear market, whatever the secular classification may be. But Dr. Hussman, for one reason or another, has kept his followers out of this bull market since day 1 on Mar 10, 2009. This has been one of the historically great bull markets, and it is not over yet. But we will have to be astute students of technical, and possibly fundamental analysis to identify the top accurately enough to preserve most of our paper capital gains. But that it is the way it is these days and will probably be for the forseeable future. In fact, that is inevitably true for all bull markets that have ever been and ever will be. The 1949-1965 and 1982-2000 bull markets were “buy and hold” periods, but even they too came to an end. Those kinds of periods are more the exception than the rule in stock market history. Identifying the top will not be easy, but it never has been. If that is too inconvenient a truth for you, then you are forever going to be riding the Wall Street Roller Coaster up and down.

Chester Shure

July 3, 2014, 9:46 a.m.

You might think abut a 10-yr trend adjusted CAPE. if you get a very high r-square, it would suggest a change in market perception of that company. That, in turn, would imply less relative risk than for unadjusted CAPE ratios.

Chester Shure

Warren Stephens

July 3, 2014, 7:41 a.m.

> “Based on valuation measures most reliably associated with actual subsequent market returns…”

Historically speaking yes, but are we in an *unprecedented* position?

1) If you *knew* that the Federal Govt can never pay off its debts,
2) and the Federal Reserve *would* eventually print money to guarantee that debt
3) Would you hold stocks at these levels?

I don’t know. 

But I do not hold any indexes—I like commodity names with long reserve life assets (its the best that I can come up with).

John White 69443420

July 3, 2014, 12:34 a.m.

tim- even for those who have been fortunate enough avoid the bears, and even if we accept QEternity, you dont have to be john maULDIN, LET alone a perma bear, to be concerned about long term gains from this juncture, Even if one believes markets are not very overvalued (CAPE is not science after all) WHAT gives you the optimism that the run up in stocks can be maintained ove the next ten years ? maybe you can time the market and get out in time -I don’t have that hubris on insider information or prescience on world events. There WILL be a correction, and the longer this float up in asste prices continues, the greater the likelihood that the correction will be abrupt and larger. We are at the zero bound, fed cant push interest rates lower..and in the next correction, if its significant and bordering on another crisis, the quiver will be empty politically and economically. Congress wont countenance another bailout on the level of 2008-9, and Chinese are unlikely to hold US bounds if we do….yellen et al have lost control of this situation, they can only sit back and wait like us, still hoping for a traditional business cycle recovery not 7 years in the running (waiting for godot ?)