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August 27, 2007

Knowing What Ain't True

John P. Hussman, Ph.D.
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Have historically reliable valuation methods become meaningless? Has the underlying relationship between valuations and subsequent market returns broken down?

The potential for historical market relationships to change, and for new methods to outperform existing ones, is a question that constantly drives our research. It's why I've done such extensive studies on discounting models, the Fed Model, interest rate relationships, the effect of buybacks, and so forth. Still, my impression is that investors are easily worried by the possibility that “this time it's different,” and by the belief that normalized P/E ratios and the like haven't “worked” in the past few years. On that issue, it's essential to recognize that valuation is not a short-tem timing tool, but has its primary effect on market returns over periods of 7-10 years and beyond.

As Will Rogers once said, “it ain't what people don't know that hurts ‘em – it's what they do know that ain't true.” The fact is that many “new era” arguments have no provable basis even in the data of the past decade, much less in long-term historical data.

Long-Term Return Projections - The Tale of Two Models

This next brief section should be my last Fed Model piece for a while :)

Consider the two alternative models below. The first presents the 7-year annual return for the S&P 500 implied by the Fed Model. The green line is based on a “normal” 10% annual total return, plus the amount of over/undervaluation implied by the Fed Model, amortized over 7 years. The blue line is the actual 7-year total return of the S&P 500.

Note that the relatively low readings in 1987 and the 1998-2000 period were the only times that the Fed Model would ever have been materially negative, and so are the only times the projected 7-year market return dipped materially below 10%.

Fed Model: Projected 7-Year S&P 500 Total Returns vs. Actual

[The above chart does not look materially different if one uses, say, the Treasury bond yield + 3% as the “normal” S&P 500 return, so I chose a constant 10% norm so that all the variation in that green line is driven by Fed Model itself.]

Now consider 7-year projections based on the simple S&P 500 price/peak earnings ratio. Note that the fit is remarkably close, even without adjusting for profit margins (which further improves the fit). Indeed, the only material outliers were the 7-year period (starting in late 1967) that ended with the brutal market lows of late 1974, and a set of 7-year periods from about 1990 to 1996 that ended in the heights of the market bubble. Note also that while the 7-year projection in 2000 was more negative than actual returns have been, those actual market returns have still been in the low single digits since 2000, and then only because valuations returned to present, still rich levels.

Price/Peak Earnings Ratio: Projected 7-Year S&P 500 Total Returns vs. Actual

[For more specifics on the above calculations, which can be easily computed, see The Likely Range of Market Returns in the Coming Decade.]

Currently, the 7-year projection for S&P 500 total returns is about 5% annually.

Look at the enormous swing from extreme undervaluation and high projected returns in the early 1980's to extreme overvaluation and low projected returns by 1998. This is the period during which the Fed Model was constructed. The essential error of the Fed Model is that it is based only on this period, and assigns nearly all the corresponding movement in earnings yields to a “fair value” relationship with 10-year Treasury yields. According to the Fed Model, the market was only slightly undervalued in 1982. That's insane. Again, my passion about this particular fallacy is that it has crept into virtually all of Wall Street's current valuation analysis, though under countless guises, such as “capitalized earnings models ” or “bond-equivalent P/Es” or “forward operating multiples.” Investors will be badly hurt by these notions.

Though the Fed Model is actually not endorsed by the Fed, neither, as it turns out, is it endorsed by the European Central Bank. The ECB nicely corroborates the findings I've repeatedly emphasized: interest rates are not unimportant, but the the level of yields - at least at observable maturities - has relatively little impact on "fair valuations." Unadjusted P/E multiples in fact do a better job of projecting subsequent returns. In contrast, interest rate trends can be very important factors affecting shorter-term stock market returns, particularly in combination with valuations. As Alain Durre and Pierre Durot conclude in a broad international study of earnings, stock prices and bond yields by the ECB:

"Our empirical results show that a long-run relationship between stock indexes,
earnings and long-term government bond yields indeed exists for many countries
(including the United States and the United Kingdom) but that the long-term
government bond yield is not statistically significant in this relationship, i.e. the long term
government bond yield does not affect the ‘equilibrium’ stock market valuation.
Focusing next on the short-term effects, we nevertheless show that rising/decreasing
bond yields do impact contemporaneous stock market returns and thus have an
important short-term impact on the stock market. The fact that the bond yield is left
out of the picture in the long-run relationship is in agreement with the academic
literature that stresses the importance of valuation ratios (such as the P/E ratio) when
appraising long-run stock market performance."

With that, I think I'm done with Fed Model studies for a while. I've done my best to warn loudly, I've put the data out there, and have analyzed this thing to pieces. The Fed Model has no theoretical validity as a discounting model, is a statistical artifact, would never have been materially negative except in 1987 and the late 1990's (even in 1929 or 1972), yet views the generational 1982 lows as about "fairly valued," is garbage in data prior to 1980, and vastly underperforms proper discounted cash flow models and normalized P/E ratios. If investors still wish to follow the Fed Model, my conscience is clear, and my hands are clean.

Again, the probable 7-year return for the S&P 500 is currently about 5% annually. Similar projections in the low single digits are common to a variety of well-constructed and historically reliable models, including those that include a proper role for interest rates (which requires consideration of both the relative duration of stocks and bonds, and the low persistence of bond yield fluctuations over time).

A Long Continued Trip to Nowhere

Remember, valuation often has little impact on short-term returns (though the impact can be quite violent once internal market action deteriorates, indicating that investors are becoming averse to risk). Still, valuations have an enormous impact on long-term returns, particularly at the horizon of 7 years and beyond. The recent market advance should do nothing to undermine the confidence that investors have in historically reliable, theoretically sound, carefully constructed measures of market valuation.

Indeed, there is no evidence that historically reliable valuation measures have lost their validity. Though the stock market has maintained relatively high multiples since the late 1990's, those multiples have thus far been associated with poor extended returns. Specifically, based on the most recent, reasonably long-term period available, the S&P 500 has (predictably) lagged Treasury bills for not just seven years, but now more than eight-and-a-half years. Investors will place themselves in quite a bit of danger if they believe that the “echo bubble” from the 2002 lows is some sort of new era for market valuations.

Since 1999, the stock market has essentially gone nowhere in an interesting way, compared with risk-free Treasury bills. Most likely, the coming 7 years will provide an equally interesting and exciting path to nowhere for the stock market.

Fed to the Rescue?

As I've noted in recent weeks, the Federal Reserve has been doing exactly what it should be doing – acting to maintain the soundness of the banking system. The Fed's intent here is not to absorb private losses. It is to make sure that banks don't have to contract their loan portfolios because of short-term withdrawals of funds. Though the Fed did open itself to slightly more credit-sensitive collateral, these securities are still investment grade and generally short-term in nature. Again, since these securities are collateral only, the creditworthiness of the underlying mortgages only becomes an issue for the Fed if the banks default on repaying their borrowings to the Fed. At that point, we've got far bigger problems.

It's important to distinguish between Fed actions to maintain liquidity in periods of crisis and Fed actions intended to affect the volume of lending more generally. As I've frequently noted, since reserve requirements were eliminated in the early 1990's on all bank deposits other than checking accounts, there is no longer any material connection between the volume of bank reserves and the volume of lending in the banking system. In normal circumstances, the Fed is simply irrelevant. The issue at present is that there is an unusual spike in the demand for reserves in the banking system. This is exactly the situation in which the Fed does have an important role.

I recognize that many investors are concerned about the potential for inflationary consequences from the Fed's operations here. However, as I've frequently noted, a sharp widening of credit spreads is an indication that there is increasing demand for the monetary base (which we observe as a decline in “monetary velocity”). In that situation, an expansion of the monetary base doesn't naturally result in inflationary pressures. The inflationary pressures may come later, if the Fed fails to absorb those reserves back from the banking system as the demand for liquidity eases back to normal. But for now, I do view the Fed's actions in terms of repos and discount window lending as appropriate.

Though the Fed will most probably cut the Fed Funds rate by half a percent, possibly all in the September meeting, or perhaps split between September and October, I don't believe that such an easing has much capacity to eliminate the inevitable default problems ahead in the mortgage market. As Nouriel Roubini has pointed out, there is a major difference between illiquidity (which Fed operations have a good potential to offset) and insolvency (which can be offset only by explicit bailouts at taxpayer expense, as we saw during the S&L crisis). My impression is that most of the worst credit risk is held outside of the banking system, so there is little concern that losses will need to be covered by deposit insurance. A greater share is probably held by investment banks and hedge funds, and my impression is that taxpayers will be hard pressed to allow Congress to use their tax money to finance the bailout of Wall Street financiers, when they've got their own mortgage bills to pay.

As a side note, I'm intrigued that investors have been so willing to lower their guard about credit concerns and the potential for continued blowups, based on nothing but the short-term interventions of the Fed. Most likely, the worst credit risks are being held in the hedge fund world, where reporting is monthly and nobody has to say nothin' until the month is over.

And on the subject of what investors know that ain't true, it's not clear that investors should really be cheering for an environment in which the Fed would be prompted to cut rates because of recession risk. Recall that the '98 cuts were largely due to illiquidity problems from the LTCM crisis, not because of more general economic risks. In contrast (with a nod to Michael Belkin), below are a few instances when the FOMC successively cut the Fed Funds rate in attempts to avoid recession: 2000-2002 and 1981-1982. Those cuts certainly didn't prevent deep market losses. Speculators hoping for a "Bernanke put" to save their assets are likely to discover - too late - that the strike price is way out of the money.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. Market breadth improved and new lows diminished, but we don't observe the elements that have typically produced market returns robust enough on which to reliably speculate. While I continue to be willing to remove a portion of our hedges (perhaps in the 25% to 40% range) if market internals improve sufficiently (without reestablishing overbought, overbullish conditions), it's important to recognize that the only reason for accepting market risk here would be speculative merit. For now, the Strategic Growth Fund remains fully hedged.

I have no particular opinion about near-term market direction. While the oversold condition of a couple of weeks ago has now been cleared, there's nothing to prevent a further “relief rally” on the hopes of a Fed safety net. One can go some distance in a mine field without anything blowing up – it's just that the overall odds aren't good. For now, market action remains unfavorable, which suggests that the enthusiasm of investors is not yet robust, and further skittishness is possible. But again, there is no particularly strong reason to expect one direction over another over the very short term. In any event, conditions remain poor from a valuation standpoint. Stocks are emphatically not “cheap.”

It's particularly interesting that the forward operating earnings crowd has advanced the notion that stocks are as cheap as they were in 1990. Aside from the problems with forward operating earnings that I've previously detailed, this particular argument rests on overlooking the state of profit margins, which were quite depressed in 1990 and are at record highs currently. Think about that for a moment and you'll see what's going on. A forward P/E multiple on depressed profit margin assumptions provides at least some margin for error. The same forward P/E based on assumptions of the highest profit margins in history contains no such margin.

Seen from another perspective, the price/peak earnings multiple was just 11 in 1990, with a long-term return projection for the S&P 500 of about 14%. Currently, the multiple is at 17.4, with a long-term total return projection of about 5%. Factoring in profit margins, the situation is worse. In any event, it's enough to study the charts at the beginning of this market comment to get a good feel for the relative validity of these alternative approaches.

In bonds, credit spreads remain problematic, but the extreme rush for safety eased a bit last week, so Treasury bill yields moved back over 4% and Treasury bond yields firmed a bit as well. The Strategic Total Return Fund continues to carry a duration of about 2 years, mostly in TIPS, with about 15% of assets allocated to precious metals shares.

It's notable how dramatically the T-bill / Eurodollar spread (TED) has blown out – this is an indication that foreign banks are hard pressed to find liquidity, and that the willing supply of deposits to foreign banks in the form of U.S. dollars has grown skittish. It's the sort of behavior we've historically seen during periods of crisis, and the wide TED spread suggests that whatever liquidity the Fed is providing to the U.S. system through repurchase agreements is not going much beyond the major banks who act as dealers. That's probably why the Fed opened up the discount window to smaller institutions. It's also notable that falling U.S. short-term interest rates resulting from economic weakness tend to have predictable and often severe negative impact on the exchange value of the U.S. dollar with a lag of about 9 months. In all, we can't rule out strong moves in either direction, but on the basis of the overall return/risk profile of stocks and bonds, a continued defensive stance remains warranted in both.

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