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January 3, 2006

Prospects for 2006

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

Happy New Year!

2005 ended in the way that many overvalued markets do – having gone nowhere, but in an interesting way.

USA Today ran a piece noting that the historical average return on stocks has been 10.4%, with various analysts voicing the opinion that, basically, last year's sub-par return increases the odds that future market performance will revert higher. That's the “gambler's fallacy” if I've ever heard it – the notion that a string of bad rolls raises the probability of a good one.

Unfortunately, in stocks, the things that produce above average returns are a) below average valuation or b) a propensity of investors to accept increasing amounts of risk, which can be largely read out of the quality of market action. Presently, we have neither. That's not to say that 2006 is destined to remain in this particularly negative Climate, but here and now, there's little to suggest the probability of above average returns until the evidence changes.

The fact is that the 10.4% historical return on stocks breaks into three simple pieces: an average earnings growth rate (measured from peak-to-peak across market cycles) of about 6%, a mild secular uptrend in price/earnings ratios over the past century, which added about a half percent to annualized returns, and an average dividend yield of just under 4%. Those pieces, by the way, are exhaustive. Mathematically, you can fully characterize the total return on stocks with a) earnings growth, b) changes in the P/E multiple, and c) the dividend yield. Note in particular that factors such as stock buybacks are already taken into account in the calculation of index fundamentals such as earnings and dividends for the S&P 500. The three factors above really are exhaustive.

Given a durable, robust historical peak-to-peak earnings growth rate of 6%, a current dividend yield of 1.8%, and a starting price/peak earnings multiple of 19, stocks are currently priced to deliver long-term returns of 7.8% annually provided that price/earnings multiples stay at a “permanently high plateau” indefinitely. Allow that multiple to contract to anywhere close to historical norms (historically, when trailing net earnings on the S&P 500 have been at a new high, the P/E ratio has averaged just 12), and stock returns have the capacity to be very unsatisfactory even over periods of 5-10 years or more. Suffice it to say that 10.4% returns are not inherent in stock ownership. Rather, long-term returns are, and always have been, a function of initial valuations (and as a tautology, ending valuations).

The CBOE volatility index ended the year about 12%. Investment advisory bullishness ended the year at a fresh 2005 high of 60.4%. Though stocks have come down somewhat from previously overbought levels, these aren't particularly strong platforms from which a sustained advance is likely. Still, we'll take our evidence as it comes. For now, the Market Climate in stocks remains characterized by unusually unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance.

In bonds, probably the most important factor in 2006 will be the behavior of the economy and the U.S. dollar. Though I'm not inclined to put much weight on projections or forecasts, the present shape of the yield curve is one that has historically been followed by a parallel upward shift in interest rates at all maturities. Given that the Market Climate in bonds continues to be characterized by unfavorable valuations and unfavorable market action, the Strategic Total Return Fund continues to carry a muted duration of about 2 years, mostly in Treasury Inflation Protected Securities. Normally, the prospect of economic weakness would provide some support for a longer duration, but the evidence on inflation is not benign. Even if we do observe economic weakness, it's not likely in my view that the Fed will have much leeway to cut rates, due to persistent inflation pressures (which have historically been associated with profligate government spending of precisely the sort that has been revived in the past few years).

In my view, the most likely accompaniment to economic weakness would not be a decline in nominal rates, but somewhat accelerated inflation (meaning that real interest rates might very well fall to negative levels), and possibly substantial weakness in the U.S. dollar. As I've noted before, the euro looks about fairly valued given the present constellation of international price levels, interest rates and inflation pressures, but the Japanese Yen and other Asian currencies still appear undervalued relative to the U.S. dollar (of course, this is why despite a certain amount of dollar weakness since 2000, certainly against the euro, we haven't seen much of a decline in the trade-weighted dollar).

As usual, I don't place too much emphasis on this sort of forecast, but to the extent that I make any comments at all about the outlook for 2006, the bottom line is this: 1) we can't rule out modest potential for stock appreciation, which would require the maintenance or expansion of already high price/peak earnings multiples; 2) we also should recognize an uncomfortably large potential for market losses, particularly given that the current bull market has now outlived the median and average bull, yet at higher valuations than most bulls have achieved, a flat yield curve with rising interest rate pressures, an extended period of internal divergence as measured by breadth and other market action, and complacency at best and excessive bullishness at worst, as measured by various sentiment indicators; 3) there is a moderate but still not compelling risk of an oncoming recession, which would become more of a factor if we observe a substantial widening of credit spreads and weakness in the ISM Purchasing Managers Index in the months ahead, and; 4) there remains substantial potential for U.S. dollar weakness coupled with “unexpectedly” persistent inflation pressures, particularly if we do observe economic weakness.

In a good outcome, stock valuations will remain elevated, inflation pressures will abate despite the recent lack of fiscal discipline, and both stocks and bonds will produce moderate but satisfactory returns in 2006. In what I view as a more probable outcome, valuations will contract modestly, the economy will slow more substantially in the mid-to-late part of the year, earnings will stall, and stock market risk-taking will be poorly compensated. Overall, the potential return/risk tradeoff isn't terribly compelling here, but again, our investment stance will change if market conditions do, particularly if we observe some improvement in the internal quality of market action.

A final note, in this first comment of 2006. As someone whose friends know as a fairly cheerful optimist, I haven't been particularly thrilled with the historical realities about valuation and the like that the market has required me to share since the late 1990's. Still, the one thing certain about markets is that they will fluctuate, and that great, exciting conditions will emerge in due time. I'd much rather be a lone bull in a cacophony of bears, but if my views are occasionally less agreeable, I hope that the analysis behind them is useful.

Wishing you a happy, healthy, prosperous, hopeful, and peaceful 2006.


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