How low, how bad, how long?
A fair bit of deliberation has taken place on this site regarding stock market valuations, and specifically what is in store for the “E” component of PE multiples. In order to cast light on this matter and to incorporate insightful research into the valuation debate, I have obtained republishing permission to share with readers a study just published by John Hussman*, president of Hussman Investment Trust. His report follows below.
With the S&P 500 down nearly 40% from last year’s highs, and now trading modestly above 10 times last year’s peak earnings level, I continue to view stocks as somewhat undervalued, in that long-term investors can expect the S&P 500 to deliver total returns in the area of 10% annually over the coming decade. This is the largest expected return premium, relative to long-term Treasury yields, since the early 1980’s.
These changes have significantly improved my views about market valuations and long-term return prospects, but I want to discourage any impression that stocks have “hit bottom” or that a new “bull market” is at hand. That sort of thinking isn’t really helpful to investors, who should always be grounded in observable evidence (rather than trying to infer things like bottoms and turning points, which can only be identified in hindsight). Frankly, the idea of identifying those things in real time is wishful thinking. Investors should not rule out a continued bear market, or deeper lows, perhaps early next year (depending on the evolution of the economic evidence). Still, even in the context of a continued bear market, we may well observe a huge 25-35% trading range as evidence develops, pushing and pulling on the perceptions and expectations of investors. Better to be comfortable with uncertainty and thoughtfully adapt to observable evidence as it develops, rather than planting a flag in the ground and being trampled from both sides.
Staying with the present moment – with what can be observed – doesn’t mean one ignores the past or fails to consider the future. Observable valuations and market action were enough to inform investors that the market outlook was precarious at last year’s peak (see 7/30/07 Market Internals Go Negative, and 10/15/07 Warning – Examine All Risk Exposures). Observable precursors of economic risk were enough to tell investors that the U.S. was headed for a recession even in November of last year (see Nov 12, 2007: Expecting A Recession).
Presently, observable evidence suggests that stocks are no longer strenuously overvalued, as they have been for over a decade (with the consequence that stocks have lagged Treasury bills over that period). Observable evidence also suggests that the washout last month was spectacular enough (and the breadth reversal substantial enough) to allow for – not ensure – a sustained advance. This could occur even within the context of an ongoing bear market, if only to allow the natural ebb and flow of data to confirm or refute the fears already impounded into stock prices. On average, similar conditions have provided a basis for strong, if impermanent, recoveries – most likely beyond the extent that we observed through last Tuesday. The selloff we saw late last week looked a lot like a standard “re-test.” A large expansion in trading volume during the next advance, whenever it comes, would add to the sustainability of a rebound.
Overall, valuations have improved enough that long-term investors should be buyers, not sellers, on any substantial weakness from here. But there is no strong reason to expect that stocks could not become even cheaper. Again, it’s likely, but not assured, that some of the recent price compression will be relieved by a substantial advance of several weeks or a few months, even if the market is ultimately destined lower.
Please click here for the rest of John’s article.
* Dr. John Hussman is the president and principal shareholder of Hussman Econometrics Advisors, the investment advisory firm that manages the Hussman Funds. He holds a PhD in economics from Stanford University, and a Master’s degree in education and social policy and a bachelor’s degree in economics from Northwestern University. Prior to managing the Hussman Funds, Dr Hussman was a professor of economics and international finance at the University of Michigan.
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