April 2, 2007
Fair Value - 40% Off (Not a Forecast, but Don't Rule it Out)
From last week's comment: " 'Predominant policy concern' - that's not a bias? From January to March, the Fed's language indicated more concern about inflation, not less. The difficulty is that the Fed can't act on these concerns because the economic situation has started to decay as well. Essentially, the Fed now has to allow for bad things to happen in both directions – continuing risks on the inflation side, and an “ongoing adjustment” in housing and the mortgage market. It also has to allow some flexibility to become a 'lender of the last resort' in case the foreclosures start to accelerate… Currently, my impression is that Wall Street has largely misinterpreted the Fed's language, and that its interpretation will be subject to an 'ongoing adjustment' in the weeks ahead."
- Hussman Funds Weekly Market Comment, March 26, 2007
From Ben Bernanke: “In our statement we said that our view was that the inflation risk was still predominant and so our policy is still oriented toward control of inflation which we consider to be at this time the greater risk. Nevertheless, the uncertainties have risen and therefore a little more flexibility might be more desirable. We believe that the housing market does present a potential downside risk to our baseline forecasts. We are watching it very carefully… I do want to emphasize that we have not shifted away from an inflation bias.”
- Fed Chairman Ben Bernanke, March 28, 2007
It should not have been necessary for Bernanke to clarify a statement that was already very clear.
With the prospect for a near term Fed cut now properly removed, Wall Street's remaining speculative hopes must now be shifted to earnings. For now, investors still seem willing to tolerate “price to forward operating earnings” multiples that are extremely elevated, because they don't even realize that these multiples are extremely elevated. Nor do they seem to realize that operating earnings have no definition under generally accepted accounting principles. Nor do they seem to realize how strong an assumption it is to believe that profit margins will remain at unusual historic highs in the face of rising unit labor costs.
These are all notions that will be disabused over time. We don't rely on investors waking up overnight. But we also are not willing to gamble our financial security on short-term hopes that the speculative mood will persist. Earnings pre-announcements will be starting soon. We should be particularly attentive to listen for the phrase “profit margins” in any forward guidance.
Long-time readers will recognize some of the following arguments from various studies I've presented in recent years, but I believe that it is important for investors to understand how profoundly incorrect and potentially dangerous it is to accept the incessant argument that stocks are cheap on a "forward operating earnings basis." As AQR's Cliff Asness has previously noted, the belief that the current “price to forward operating earnings” multiple is reasonable is based on an apples-to-oranges comparison. It is the trailing P/E on reported net earnings that has a historical average of about 15, not the forward P/E on estimated operating earnings (which Asness estimates as having a historical norm closer to 11).
Even that average for the trailing P/E is itself biased upward because earnings typically collapse during recessions, driving P/E ratios to extreme levels during those periods. Those get added into the average, and results in a “historical norm” of 15. If you correct for those spikes, the historical average P/E for the S&P 500 is even lower.
To correct for the uninformative spike in P/E ratios during recessions, we can make the assumption that a given earnings level, once achieved, is likely to be achieved again even if the economy encounters temporary weakness. While that's not necessarily a reasonable assumption for an individual stock, it is much more reasonable for a diversified index like the S&P 500. Forming price/earnings ratios on the basis of the peak level of earnings-to-date (what I call the price/peak earnings ratio), we get a much better behaved measure of valuations that is more reliably correlated with subsequent long-term returns. Note that the word “peak” doesn't imply that earnings are about to decline – only that the P/E calculation uses the highest level of earnings achieved to-date.
On that basis, the current price/peak earnings ratio is about 17.5, well above the historical average of 14 for the price/peak earnings ratio.
But we're just getting warmed up. If we look closely at S&P 500 earnings, we find that we can draw a 6% growth trendline connecting earnings peaks from economic cycle to economic cycle as far back as we care to look. So even though earnings sometimes grow rapidly from the trough of a recession to the peak of an economic expansion, at rates sometimes exceeding 20% annually, we also find that the peak-to-peak growth rate has been very well contained historically at just 6%.
Unfortunately, if we a) calculate the S&P 500 price earnings ratio based on those “trendline” earnings or b) look at periods where actual earnings were within 10-20% of that trendline connecting historical earnings peaks, we find that the average S&P 500 price/earnings ratio drops to just 10.
Currently, S&P 500 earnings are again at that trendline. In fact, given the unusual spike in profit margins, they have actually moved slightly (but not significantly) above that line. On that basis, the current price/earnings ratio, normalized for the position of earnings at present, is about 75% above its historical norm (alternatively, the historical norm would be about 40% below current levels).
That's not, by the way, the level at which we would observe deep undervaluation. The extreme 1974 and 1982 troughs, for example, occurred at price/peak earnings ratios of 7 and price/trendline earnings of about 6. Given the current multiple of 17.5 times those trendline earnings, I am certainly not suggesting any probability of the market moving to such levels. But to rule out a decline of 30-40% on the S&P 500 would be to rule out a move to valuations that have historically been standard, normal, commonplace.
Interestingly, that same extent of overvaluation is also implied by a completely different approach (see the market comments of September 12, 2005 The S&P 500 as a Stream of Payments and March 21, 2005 Don't Discount Discounted Dividends). In the discounted payments study, I asked:
“Suppose we look back over history, and at each date, add up all the dividends the S&P 500 actually delivered over the subsequent years, discounted at a long-term rate of return of 10%. We could literally check whether investors got what they paid for.Of course, the more recent the date, the more we'd have to project some future dividends. But that's not a terribly difficult matter. As it turns out, the average dividend growth rate since 1900 has been about 5%, the average since 1940 has been 6%, and the highest growth rate for any 30-year period has been 6.4%. We also know that S&P 500 earnings growth has displayed a very, very durable 6% growth rate measured from peak-to-peak across economic cycles. So assuming anything between 6% to 7% long-term dividend growth will give us a very robust series of likely future dividends.”
You can refer to the original studies for further details, including the impact of repurchases and alternative assumptions. For our current purposes, the following chart presents the analysis of the S&P 500 using this methodology, from 1900 to the present.
Essentially, that green line is a fairly robust estimate of where the S&P 500 would have to trade in order for stocks to be priced to deliver long-term returns of 10% annually. When the actual S&P 500 (blue line) is above that green line, we don't have to conclude that the market is “overvalued” – just that it's a good likelihood that stocks are priced to deliver long-term returns of far less than 10% annually from those levels.
Where is that green line today? 850 – about 40% below current levels.
Again, that doesn't imply that stocks have to actually suffer a decline of that magnitude. Nor do we need such a decline in order to justify an unhedged investment stance. It's just that investors should not expect the S&P 500 to reliably deliver long-term returns of 10% annually or better until it does. You'll note that there are also points in history when the S&P 500 traded substantially below that 10% valuation line. Those were points where stocks were priced to deliver long-term returns reliably above 10% annually, and in fact, they did exactly that.
Presently, we're not anywhere close to such a situation. Food for thought.
No change in the Market Climate for stocks, bonds or precious metals here. As of last week, the Market Climate for stocks was characterized by unfavorable valuations, still moderately constructive price trends, but also a combination of overvalued, overbought, and overbullish conditions that has historically been associated with S&P 500 returns below Treasury bill yields. The Strategic Growth Fund remains fully hedged against the impact of market fluctuations at present.
In bonds, the Market Climate was characterized by unfavorable valuations and relatively neutral market action. The Strategic Total Return Fund had a duration of about 2 years, mostly in Treasury inflation protected securities, with a position of just over 20% of assets in precious metals shares, where the Market Climate remains favorable on our measures.
Prospectuses for the Hussman Strategic Growth Fund and the Hussman Strategic Total Return Fund, as well as Fund reports and other information, are available by clicking "The Funds" menu button from any page of this website.
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