May 16, 2005
Sleight of Hand
During my high school years, before I accumulated enough amplifiers to play in a rock band, I worked as a stage magician and ventriloquist. Magic relies on the art of substitution - displaying something to the audience, and then subtly exchanging it with something else (or nothing) in a way that violates their expectations (see How to Make a Quarter Disappear). The punch line of a joke also gets its effect from some kind of substitution or shift in perspective that comes as a surprise.
In order to avoid similar, but often unpleasant surprises, it's important for investors to be aware of the quiet substitutions regularly made in corporate reports and investment analysis. For example, compensating management and employees with stock options is a subtle way of increasing reported earnings by substituting cash payments (payroll) with "non-cash" payments (stock). Unfortunately, the new FASB rules on expensing options do an atrocious job of actually reflecting the dilutive impact of these options, since their true cost is measured not by a one-time deduction of their value at issuance, but by their value at exercise (an annual accrual would be the appropriate way to do this properly).
More recently, investment analysts have again begun playing fast and loose with price earnings ratios. For example, it's common these days to hear that "stocks are selling at just 16 times expected operating earnings, which not much higher than the historical average P/E of 15."
There are, in fact, several distinct twists of the hand that produce this statement. Notice first that the "historical average P/E of 15" is based on trailing net earnings for the S&P 500 - that is, earnings for the prior year, inclusive of extraordinary losses and other deductions. But the comparison above substitutes "trailing" with "expected" and "net" with "operating," resulting in an earnings figure that is about 30% higher (and producing a correspondingly low P/E). Cliff Asness of AQR Capital estimates that the proper historical P/E for the S&P 500, on the basis of expected operating earnings, is something less than 12.
Worse, historical average P/E multiples are themselves biased upward by recessionary periods when earnings were temporarily depressed, producing very high P/E multiples. In contrast, both trailing net earnings and expected operating earnings currently represent record highs. So part of what's going on is that these analysts are comparing a current P/E based on record earnings (producing a lower multiple) with a historical average P/E based on frequently depressed earnings (producing a higher benchmark).
The upshot of all of this sleight of hand is something akin to turning a bird into a handkerchief. We are shown one thing, and suddenly it transforms into something entirely unrelated.
Unfortunately, the actual valuation picture here is much more stark. Currently, the S&P 500 trades at about 20 times trailing net earnings, which represent a record for trailing earnings. Historically, when S&P 500 earnings have been at a fresh record, the price/earnings multiple has averaged just 12. If we expand the data set to include all historical points (whether earnings were at a record or not) but construct the P/E ratio based on the then-prevailing record level of earnings, the historical average price/peak-earnings ratio was about 14. Yet even the comparison between 20 and 12-14 is somewhat generous, because profit margins (which have been clearly mean-reverting over long stretches of history) are currently unusually elevated on a historical basis. If you look at multiples like price/revenues, price/book or price/dividends, you find that current multiples are closer to double their respective historical averages. And while analysts often appeal to low interest rates and inflation to justify current multiples, the fact is that the bulk of history prior to 1965 featured interest rates and inflation near or below current rates, yet we've only witnessed valuation multiples of 20 times peak earnings a handful of times, including the 1929, 1972 and 1987 market peaks.
The picture is not entirely bleak, however. We also saw a price/peak earnings multiple of 20 on the S&P 500 in October 1996, near the beginning of the late-1990's market bubble. Now, forget for a moment that the S&P 500 has underperformed even the depressed returns on Treasury bills over the past 7 years (specifically, since February 1998). If you measure from October 1996, when the S&P 500 price/peak earnings multiple was 20, to the present, when the multiple is still 20, it turns out that the S&P 500 has delivered a modest but respectable annual total return of 7.6%. Indeed, this is what we would have expected. If the P/E multiple stays constant between two points, the total return on the index will be equal to the average annual rate of earnings growth (about 6% in this case), plus the average dividend yield over the holding period (about 1.6% in this case).
So we can confidently say that provided the S&P 500 P/E stays at an elevated multiple of about 20 into the indefinite future, stocks might reasonably produce annual total returns somewhere between 7-8% from here. Remember the assumption, though, is that valuations will remain at the current level indefinitely (again, matching levels previously observed only at major historical peaks, and during the froth of the late-1990's market bubble).
More likely, assume that S&P 500 earnings continue to grow at the long-term 6% peak-to-peak rate that has contained earnings for the past century, and that the price/peak earnings ratio reverts to a still above-average level of 16 about 5 years from today (the typical bear market low has historically taken the multiple closer to 11, while durable troughs such as 1974 and 1982 reached as low as 7). In that event, given a current 1.8% dividend yield, we can estimate that the average annual return on the S&P 500 over the coming 5 years will be [(1.06)(16/20)^1/5 + .018(20/16+1)/2 - 1 = ] 3.4%.
While a defensive investment position may very well forego periodic short-term rallies, I do not believe that it is likely to sacrifice long-term returns here. To the contrary, the flexibility to vary one's investment stance based on prevailing market conditions, particularly valuations, will most probably be essential to investors focused on achieving strong risk-adjusted returns over time.
As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and unfavorable market action. There remains some potential for investors to display a fresh willingness to accept market risk, but based on widening credit spreads (the difference between the yields on risky and high-grade debt), weak breadth as measured by declining versus advancing issues, and numerous market internals and industry measures, that chance is gradually fading. As usual, we're flexible enough not to require or rely on the continuation of any particular Market Climate, but for now, the Strategic Growth Fund remains defensive, with its diversified stock portfolio fully hedged with an offsetting short position in the S&P 100 and Russell 2000 indices. This hedge is not a "bearish" position, but strictly a "defensive" one intended to remove the impact of market fluctuations on the portfolio as much as possible.
In bonds, the Market Climate remains characterized by moderately unfavorable valuations but only slightly unfavorable market action. Widening credit spreads, in particular, are often a favorable portent for Treasury bonds, because they are typically associated with a subsequent weakening in the economy. With yields relatively low, however, the case for longer-term bonds is not as solid as it would be if we observed widening credit spreads at higher absolute yield levels.
The potential for inflation pressures also seems stronger than widely recognized because of the combination of velocity pressures (tied to rising short-term interest rates), potential yuan revaluation, and a continued lack of fiscal discipline. The U.S. dollar is also now sufficiently overbought that commodity prices could spike abruptly higher here. For now, we're still holding to a modest 2-year average duration in the Strategic Total Return Fund, with just under 20% of assets allocated to precious metals shares.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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