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March 27, 2006

The Big Chair

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

On a street in a little town in Canada, there's a chair that's about twice the size of a normal adult, which as you can see, makes your normal adult look fairly small.


(Blurred, in the unlikely event that Jean Claude or Rhobes Pierre would object...)

Presently, S&P 500 earnings are a lot like that chair.

Specifically, the price/earnings ratio on the S&P 500 is about 18.2, which as noted in last week's comment, doesn't look particularly bad. On closer evaluation, however, it's a starkly misleading figure. Put a couple of adults in a really big chair, and they'll look small anyway. Divide the S&P 500 index by a very elevated earnings number, and it'll look reasonably valued.

As noted last week, S&P 500 earnings are currently at the peak of a long-term 6% growth line that has connected cyclical peaks in S&P earnings going back as many decades as one cares to look (this doesn't mean that the growth rate from every single peak to the next one is 6%, but as you can quickly observe from last week's chart, a simple 6% peak-to-peak trend does a good job of describing the entire growth history of earnings). What's important here is that excluding the late-1990's bubble peak, if you examine other periods when S&P 500 earnings have even been close to that trendline (say, within 20%), the average price/earnings ratio for the S&P 500 index has averaged just 9 or 10 – about half current levels. As usual, that's NOT to imply that stocks are about to drop in half, but investors should certainly not look carelessly at a market trading at 18.2 times top-of-channel earnings.

It's interesting that the current P/E is about double its “normal” level based on the current position of earnings. If you look at the price/book ratio on the S&P 500, at 3.1, it's also about double the historical norm of about 1.5. The price/dividend ratio on the S&P 500, at 54, is about double the historical norm of about 26. The price/revenue ratio on the S&P 500, at 1.5, is nearly double the historical norm of 0.8. This market isn't cheap.

And yet, we look at the P/E ratio, and it's only 18, and even lower if you exclude some charges and use “operating earnings.” We're used to thinking of a P/E of 15 as about average, historically. What's going on?

Essentially, the widely quoted historical average of 15 for price/earnings ratios is based on trailing net earnings (the ones that conform to generally accepted accounting practices, not "operating earnings" for which no GAAP definition exists). It also includes a lot of periods where earnings were quite depressed (which raises the corresponding average P/E). If you look at points where earnings were actually at a record, the average P/E drops to about 12. If you look at top of channel earnings along that 6% long-term growth trend, the average P/E drops to 9 or 10. Meanwhile, profit margins are unusually rich here – about 8% compared with a fairly robust historical norm of about 6%. That phrase “fairly robust” is another way of saying that profit margins have a strong tendency to revert to normal – certainly not over a period of months, and often not even over a full market cycle – but over time. Competitive economies are very good at eliminating unusually high profit margins.

From an economic perspective, corporate profits as a share of GDP are near an all-time high. Historically, a high profit share relative to GDP has generally been followed by disappointing earnings growth over the following 5-year period. This appears particularly likely here, given the unusually low share of corporate revenues currently going to labor compensation (see the August 8, 2005 comment), and the fact that real wage pressures are now building.

One might argue that the pool of cheap labor is so large, globally, that real wages in the U.S. should be held down for quite some time. My impression is that investors shouldn't overly count on this. The vast majority of labor hired by U.S. corporations is domestic, and labor conditions, though not extremely tight, are tight enough to explain the recent upward wage pressures.

[Geek's note: What's worse, nearly all the growth in U.S. domestic investment since the mid-1990's has been financed by imported capital – which we observe as a current account deficit – so that the observed “productivity boom” has gone hand in hand with an expansion in imports (see the November 10, 2003 comment). To the extent that we now have an intolerably deep current account deficit, the U.S. is likely to observe restricted growth in capital investment in the coming years, which will tend to be a drag on productivity even while real wages increase. The resulting squeeze on profit margins may be acute within a few years.]

In short, the S&P 500 is richly valued on the basis of nearly every fundamental measure, including earnings when those figures are properly considered. The point is not to predict a near-term decline in stocks, but rather to emphasize that the long-term returns priced into stocks here are likely to be disappointing. Given that stocks are unlikely to produce much, if any, risk premium versus risk-free Treasury yields, it follows that a hedged investment position is unlikely to diminish long-term returns, though hedging is clearly likely to reduce risk. Until we observe better valuations, or market action that suggests that investors have a strong appetite for risk despite unfavorable valuations, the case for hedging our stock holdings will remain compelling – perhaps not from a short-term trading perspective, but comfortably for longer term investors.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and approximately neutral market action. The stock market has gone an uncharacteristically long time without even a 10% correction. That alone is not a reason to expect one, but valuations and uninspiring price/volume action in the market suggest that a sizeable correction should not be ruled out. Presently, the Strategic Growth Fund is fully hedged against the impact of market fluctuations, but we may accept a modest amount of market risk (say up to 20-25% of portfolio value) if the market were to pull back without much internal deterioration.

In bonds, the Market Climate remains characterized by unfavorable valuations and unfavorable market action, holding the Strategic Total Return Fund to a roughly 2-year duration in Treasury securities, while the Fund also holds about 15% of assets in precious metals shares.

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