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December 12, 2005

A "Durable Sense of Doom"

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

“We learn from history that we do not learn from history”

- Hegel

Let me note right from the start that this is not a "bearish" comment from the standpoint of short-term market direction (which could go either way). Rather, it's a note of serious concern about the long-term prospects for long-term investors buying and holding the S&P 500 or other broad market portfolios - particularly for investors who have retired or are investing lump sums at current levels, and who don't plan to add significantly to their invesments over time with new savings.

[In contrast, investors following disciplined, long-term saving and investing strategies, such as dollar-cost averaging, should stick to their discipline, even if they've chosen index funds as their vehicle. If your current investments are relatively small compared with the future savings that you plan to invest, you can safely ignore concerns about valuation because your continued discipline and future investments at a variety of other valuation levels will be the cornerstone of your financial security. Regular saving and investing is an essential practice even for index investors].

During the past few years, there's been an emerging tendency of investors to restrict the term “overvaluation” to the single period surrounding the 2000 market peak. That, unfortunately, requires thinking persons to dismiss the entire historical record of the stock market prior to about 1995. With minor exceptions, the past decade has been spent in the top quartile of post-war market valuations, and in an even thinner top layer of the market's valuation range over the past century.

Historically, durable bear market troughs – of the sort which have reliably produced long-term returns of about 10% or more over a variety of time horizons – have occurred at average price/earnings multiples near or below 11 (as usual, I generally calculate market P/E multiples on the basis of the price/peak-earnings ratio, where the denominator is the highest level of trailing net earnings attained for the S&P 500 as of the date of the calculation).

In fact, most of the explosive first-year gain of historical bull markets has represented a move up from P/E ratios averaging 8 or 9 (even lower in 1974 and 1982) toward a multiple of 11. Nor are multiples like that antediluvian – the S&P 500 last saw a price/peak earnings multiple of 11 in the early 1990's. For the record, the Los Angeles Times called me “one lonely, raging bull” at the time, though there's nothing, in my view, that would prevent an aggressive investment position from being acceptable even at modestly above-average levels of valuation.

At a multiple of 19 times fresh record earnings, however, it would require a complete lapse of historical memory, research findings, and I think, fiduciary duty, for me to take an aggressive exposure to market fluctuations with shareholder assets here. It just won't happen at these valuations. Barring more compelling valuation and economic conditions, even a shift to more uniform, better quality market action would probably move the Fund to something less than a 40% exposure to market fluctuations at present.

Keep in mind that historically, major market peaks rarely achieved even 19 times prior record earnings, and even the 1929 and 1987 peaks failed to surpass a multiple of 21. In short, current valuations are of the sort that generally produce poor short-term market outcomes, not to mention poor long-term ones. For our purposes, it would still be reasonable to accept a modest exposure to market fluctuations if the quality of market action showed greater uniformity. But here and now, it's difficult to find even speculative merit to market risk here, unless one is willing to take that risk solely on the basis of hopes for further (dubious) seasonal strength, or just plain hope that the market's recent rally will continue.

So with valuations unfavorable and, at present, our measures of market action continuing to act unfavorably as well, we retain, as J.K. Galbraith once put it, “a durable sense of doom.” It's not that stocks “must” or “should” decline over the short-term and in this specific instance, but rather that the evidence suggests very disappointing average outcomes from conditions that have historically matched present ones.

That's particularly true over the long-term, where really, investors' attention should be focused anyway. Think of it this way – a price/peak-earnings ratio of 11 is actually the long-term historical median. Deep undervaluations like 1974 and 1982 took the market's P/E below 7, but a defensive position doesn't require anything close to that expectation. It would take only a move to historically average valuations, at some very distant point in the future, to produce very poor investment returns over the very long-term.

Last week's comment displayed the robust long-term path of peak-to-peak earnings, which have grown no faster than 6% historically – even during the past decade or two. Assuming a continuation along the top of that trajectory, it's simple algebra to estimate very long-term investment returns (estimates which, as noted in the February 22 comment, have generally been very accurate in containing decades of actual market data).

Suppose for example that however the market might behave over the next few years, it eventually touches – just touches – its historical average price/peak-earnings multiple of 14, say 15 years from now. Given a consistent 6% peak-to-peak earnings growth rate, a current multiple of 19 times peak earnings, and a current dividend yield of 1.8%, the resulting estimate for 15-year total returns is [(1.06)(14/19)^(1/15) + .018(19/14+1)/2 = ] 5.99% annually.

The median multiple of 11, touched momentarily, a full 30 years from now, just once, results in a total return from now until then of [(1.06)(11/19)^(1/30) + .018(19/11+1)/2 = ] 6.54% annually.

That's just not kind math. It implies that for long-term investors, a constant exposure to market risk and fluctuations – regardless of short-term outcomes – is unlikely to produce anything close to satisfactory returns unless stock valuations remain forever above their historical mean and median levels.

It's a simple fact that long-term investors have historically never been penalized for taking defensive positions at high valuations. Sure - absolutely - they may forego short-term returns that occur at high valuations from time to time. Indeed, we're perfectly willing to accept some – and in certain cases substantial – exposure to market fluctuations despite rich valuations, provided that market action has enough quality to warrant the risk. But even though our attention to market action may produce better results by allowing somewhat more “nimble” investment positions, good value investors can still do fine without it – they just require a more durable sense of doom than is probably necessary.

In any event, with both valuations and market action unfavorable here, our investment position remains defensive. That may change somewhat if the market recruits more favorable internals and so forth, but until that evidence emerges, the Strategic Growth Fund will remain defensive toward overall market fluctuations. As usual, investors seeking a short-term “market timing” approach, or a vehicle that constantly “tracks” market fluctuations, should consider the Strategic Growth Fund to be an inappropriate vehicle for their goals. The Fund is appropriate for investors interested in strong long-term investment returns over the full market cycle (both bull and bear markets combined), managed risk, and added emphasis on capital protection in conditions that have historically been unfavorable toward stocks.

As it happens, those unfavorable conditions remain clearly evident at present, and our investment position will change as new evidence emerges.

Market Climate

As noted above, the Market Climate for stocks remained characterized last week by unusually unfavorable valuations and unfavorable market action. Enough said.

In bonds, the Market Climate also remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Total Return Fund to a short 2-year duration, mostly in Treasury Inflation Protected Securities, with a position still just under 20% in precious metals shares, where I continue to clip off modest exposure on short-term strength to keep the position generally under 20% of assets.


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