HUSSMAN: MORE EVIDENCE OF GROSS OVERVALUATION
In his latest letter John Hussman said the market was over 40% overvalued. Well, he’s tracked down more evidence to prove his point. This time Mr. Hussman points to Tobin’s :
“More sober and historically reliable measures of market valuation create a much more challenging picture. Apart from our own measures, which indicate continued overvaluation, there are several good indicators of market valuation that are not overly sensitive to year-to-year fluctuations in profit margins. One is based on the 10-year average of actual net (not operating) earnings, which is advocated by economist Robert Shiller, and another is Tobin’s “q” ratio which is based on comparing market value to replacement cost, and is advocated by Andrew Smithers. Both of these measures largely agree with our own measures, both presently and on a historical basis. Based on last week’s valuations, both suggest that the S&P 500 is substantially overvalued.”
“[Geek's Note: The chart above is based on the ratio of the CAPE and q to their respective historical averages. Note that the axis is logarithmic, so the level of 0.4 corresponds to a valuation ratio of exp(0.4). This is about 1.5, or 50% overvalued. In contrast, major secular buying opportunities as we observed about 1950 and again in 1974 and 1982 occurred at values of about -0.6, which corresponds to a ratio of log(-0.6). This is about 0.55, implying that the market at those points was about 45% below historical norms.]“
Source: Hussman Funds
Here is another article on earnings from Hussman
http://www.hussmanfunds.com/rsi/
Dr. Hussman has fallen into the “Dead Duck Trap” or “How can these dead stocks/companies get up and fly”– “Miracles on Wall Street “
What are you supposed to do wait 20 years for an entry point? Stay away from the S&P.
TPC,
Respectfully I would love your commentary on the FED rumor to stop paying the .25% on reserves. Much ADO about nothing?
Trend earning are $54.60 per the Shiller data. The amount of overvaluation depends on the PE multiple you apply. The long-term average PE using all data since 1871 is 16.4. That implies fair value of 895, which happens to be where Grantham currently sets SP500 fair value (about 12% over the 1010 level we recently saw intraday.) Excluding the bubble period from 1995 to mid-2008 from the Shiller data, results in an average PE10 of 14.8, but that also then includes multiple depression periods, especially the post WW1 bust and the Great Depression, not to mention depressed PEs during the hyperinflationary 70s and early 1980s. Excluding both the major bubbles and busts the PE10 is about 15.5. That implies a fair value of about 850. At 1032 (June close) the SP500 is somewhere from 15% to 30% overvalued based on PE10. Certainly not cheap, but probably a positive real return over the next 10 years. (Maybe giving up 0.5% to 1.0% real over the next 30 years versus long-term average returns). And much cheaper than at any time since before 1995 (excluding the buying opportunity from October 2008 to July 2009.)
The opportunity for gain at a low valuation is much higher than at a high valuation but you can still wait for years for your purchase to pay off. Vice versa for high valuations.
If you bought at the bottom in 1974 you waited 10 long years before you saw a really big payoff, but your risk of further loss was small. On the other hand if you got out of the market in 1995 due to the historically high valuations (PE10 at 25) then you had to wait 13 years until 2008 for valuations to come down below a PE10 of 20 and you missed the end of the 1990s bull market and the cyclical bull from 2002 to 2007.
Sentiment drives PE. Should it be 6 (ultimate bear market) or 26 (Fed induced suger high)? Probably neither. Ultra cheap short-term financing (free money from the Fed) offsets bad economy and maybe results in an average to slightly high PE.
I bet those hoping for a crash to new lows and those hoping for a recovery to anything like the old highs are both sadly disappointed.
Most likely is a range bound market going up and down (maybe between 800 and 1300 with a midpoint at 1050) for several years (maybe Grantham’s seven lean years) and ending right about where we are now.
SP500 at 1100 has a magnetic pull. 200 day MA or 200 month MA. Both fit.
Rob: Great comments. I gravitate toward an average PE10 of 16 (very close to your 15.5) which is 1) the 50 year period prior to 1995, 2) the last 100 year average of all years, and 3) the number Shiller himself uses.
While your point about the possibility of a range bound market is well taken, history also presents the case that – at market lows – not only do the PEs revert to their average, but they overshoot them (as Hussman’s chart shows). So while I’m not an alarmist or pessimist, a very reasonable case could be made that the market could go considerably lower than 850.