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June 19, 2006

S&P 500 Fair Value Below 800?

John P. Hussman, Ph.D.
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The S&P 500 has underperformed the total return on lowly 3-month Treasury bills for what is now more than 8 years, earning average annual total returns of just 3.2% since early-1998. Over the past decade, the S&P 500 still sports an unimpressive annual total return of just 8.20%, despite containing the best 4-year market performance (1996-2000) since the rally from post-depression lows in the 1930's.

The disappointing performance of the stock market over the past 8-10 years underscores two facts. First, valuations may not matter much over the short-term and even over periods of a few years (especially when the quality of market action is uniformly favorable, as it was during the late 1990's), but they are the overriding determinant of long-term returns. Second, once valuations become elevated, defensive risk-management does not detract importantly from long-term returns.

Valuations say something about the “investment merit” of stocks. Stocks are nothing but a claim on a long-term stream of cash flows that will be delivered to investors over time, and valuations indicate the extent to which those expected future cash flows are priced to deliver reasonable long-term returns. However, there can also be “speculative merit” to maintaining a constructive investment position even when valuations are elevated, provided that the quality of internal market action is uniformly favorable.

Sometimes, there is simply no point to retaining an exposure to market fluctuations at all. When valuations are rich, interest rates are rising, and internal market action displays wide divergences and “heavy” price/volume action (indicative of waning sponsorship and a deteriorating willingness of investors to accept market risk), there has been no benefit historically in maintaining even a speculative exposure to market risk. During such periods, hedging against the impact of market risk actually reduces volatility while typically increasing long-term returns (though not necessarily short-term returns since one will tend to miss periodic short-term rallies).

S&P 500 fair value below 800?

The chart below updates my September 12, 2005 study on the S&P 500 as a discounted stream of future dividends. The blue line is the actual value of the S&P 500 since 1900. The green line is the level at which the stream of S&P 500 dividends (including the implied effect of repurchases) would have actually been priced to deliver a long-term total return of 10% to investors, based primarily on the payments that were, in fact, delivered over time (see the original study for details on repurchases, terminal values, and other explanatory notes).

Though we don't know the exact payment stream that the S&P 500 will deliver from here on out, long-term growth rates for dividends and peak-to-peak earnings on the S&P 500 are remarkably well-behaved and predictable within a narrow range. Using a 6% assumed long-term growth rate of dividends (matching the peak-to-peak historical growth rate of S&P 500 earnings), the index level currently required to deliver a 10% long-term total return to investors would be 652 (the S&P 500 currently trades at 1251.54).

The actual growth rate for S&P 500 dividends since 1940 has averaged just 5.7% annually. Using that growth rate, the implied value of the S&P 500 is just 607. Using more optimistic assumptions, the fastest 25-year growth rate for S&P 500 dividends over the past century has been 6.7% annually. If we assume that growth rate for future dividends, the implied value of the S&P 500 would presently be about 788. Though the higher range of that 607-652-788 area seems about right to me, given other information such as earnings, profitability, and so forth, all of these figures are plausible regions of “fair value” on the assumption of 10% long-term equity returns.

One might scoff that such levels on the S&P 500 would put its price/earnings ratio at about 10, but that is, in fact, about the price/earnings ratio that the S&P 500 has averaged when earnings have been at fresh highs near their long-term 6% peak-to-peak growth trendline (as they are currently). The belief that price/earnings ratios should “normally” be much higher is based on earnings that have typically been well below that peak-to-peak growth trendline. You don't pay rich multiples on peak earnings and record profit margins late in an economic expansion if you want to keep your money.

Of course, it is possible to “fit” the green line so that it matches the value of the S&P 500 at current levels. This requires the assumption that the long-term dividend growth rate will be 8%. Not only has that never been observed historically, and not only is it inconsistent with the constraints imposed by nominal GDP growth, but that assumption also implies that stocks were fairly valued at every previous market top except 1929 and 2000, including 1972 (just before the S&P 500 lost half of its value) and the 1987 pre-crash peak. Reasonable assumptions should generally be at least slightly consistent with observable facts.

Historically, deviations between the actual S&P 500 value and the implied fair value (depicted above) have displayed a 70% correlation with subsequent 10-year returns on the index (a lack of explanatory value would be a 0% correlation). In other words, the stock market has historically had a strong tendency to deliver above-average returns from favorable levels of valuation, and to deliver unsatisfactory returns when valuations have been elevated (as they are today).

In my view, the stock market remains richly valued, and investors should not rule out an S&P 500 trading in the 700-800 range in the years ahead as a reasonable (not catastrophic) probability. Investors should not be misled to believe that broad exposure to stock market risk represents sound investment here, or that a shallow decline of a few percent has suddenly made the stock market a bargain.

Market Climate

As of last week, the Market Climate in stocks remained characterized by unfavorable valuations and unfavorable market action. The Strategic Growth Fund remains fully hedged, with a diversified portfolio of individual stocks and an offsetting short position of similar value in the S&P 500 and Russell 2000 indices. When the Fund is in such a position, its returns are driven by several factors – the implied interest on the short position (generally between the 3-month Treasury bill rate and the broker call rate – currently about 5%), plus the difference in performance between the portfolio of stocks owned by the Fund (after expenses) and the indices we use to hedge. To provide shareholders with an understanding of what drives Fund returns, the performance chart of the Fund separately presents the Fund's overall returns, the performance of its stock portfolio (after expenses) without the impact of hedging transactions, and the S&P 500 and Russell 2000 indices, which we use to hedge market impact.

Last week contained a typical fast, furious, prone-to-failure advance, which should be fully expected from time-to-time in order to clear periodic “oversold” conditions that develop in the market. Unfortunately, when the Market Climate is unfavorable as it is currently, the market can become persistently oversold, so it is generally a very bad idea to try to “scoop up bargains” even on a trading basis in hopes of a short-term “clearing” rally.

You can think of both advancing and declining markets as operating in “trend channels” that contain the market's fluctuations. As a rule, when the market is in an uptrend (or in our case, if the Market Climate is favorable), you typically want to buy the middle of the trend channel and below. You do not, however, get cute and set yourself against prevailing market conditions by trying to sell the top of the channel. You can lighten up on positions that look over-extended, but you don't fight the prevailing Climate. Similarly, when the market is in a downtrend (or in our case, when the Market Climate is unfavorable), you want to sell the middle of the trend channel and above. You do not, however, try to buy the bottom of the channel and establish a position that goes against the prevailing evidence.

So while the Market Climate is unfavorable here, shareholders should allow for the possibility of (but not rely on) periodic “clearing rallies” when the market becomes oversold from time-to-time. These are neither safe enough nor reliable enough to use as trading opportunities, but they are going to happen periodically. It's the nature of declining markets to give hope to investors that things are coming back, the same way it's the nature of slot machines to pay off from time to time as they gradually take away your money. Intermittent reinforcement is what keeps the game going.

In bonds, the Market Climate remained characterized last week by relatively neutral valuations and relatively neutral market action. In the Strategic Total Return Fund, we boosted our exposure in precious metals shares to about 15% of assets on substantial price weakness in that group last week. On the fixed income side, credit spreads are creeping higher, but have not displayed the sort of widening that would prompt an important increase in our portfolio duration just yet. If we observe some further price weakness in inflation-protected securities, I would be inclined to modestly increase our portfolio duration in that class of investments. For now, the Fund carries a duration of about 2.5 years, mostly in TIPS.

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