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October 11, 2010

No Margin of Safety, No Room for Error

John P. Hussman, Ph.D.
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Over the past 10 years, the S&P 500 has achieved a total return, including dividends, averaging -0.03% annually. Over the past 13 years, the total return for the S&P 500 has averaged just 3.23%. Why have stocks performed so poorly? One word. Valuation. If investors take nothing else from these commentaries, there are two primary lessons that should be clear. First, the poor market returns that investors have achieved for more than a decade were entirely predictable during the late 1990's, based on the historical relationship between valuations and subsequent returns. Second, from current valuations, the similarly poor returns that investors are likely to achieve over the coming 5-7 year period are also predictable based on the same evidence.

While we regularly emphasize that valuation is not particularly useful as a timing tool, we know of no factor with a better record in setting expectations for long-term market returns. We spend a great deal of time discussing market conditions, economic policy, investor sentiment, and other factors in these weekly comments. But it is critical to recognize that these factors simply modify the short-term course that market returns take over periods of perhaps 1-2 years. They do not significantly affect the long-term course of market returns. Once valuations become unusually rich, disappointing long-term returns become baked in the cake.

We frequently cite our projections in terms of 10-year returns, since that horizon is a common definition of "long-term." Generally speaking, however, large deviations of market valuations from their historical norms have generally been corrected within about 7 years. As a result, 7-year return projections are somewhat more sensitive to overvaluation and undervaluation than 10-year returns are. Think of it this way. Suppose that stocks achieve sub-par returns of 2% annually in order to correct an initial overvaluation, but that after 7 years, valuations are once again normal enough for stocks to achieve 10% annually over the next 3 years. Clearly, the 7-year total return is simply 2% annually. The 10-year total return is a bit less hostile, at 4.34% annually.

I remain concerned about the likelihood of a second economic downturn, and find little in the recent economic evidence (including last week's employment report and the negligible shift in the ECRI Weekly Leading Index to -7%) to reverse that view. That said, we do not rule out the potential for an improvement in economic tone, and will respond to that evidence if and when it emerges.

More importantly, however, investors should recognize that the presence or absence of immediate economic pressures does nothing to change the likelihood that stocks, from their current valuations, will achieve negligible returns in the coming 5-7 years. To understand this, investors need to ground themselves in exactly how reliable valuations - based on smooth, low-variability fundamentals - have been in explaining subsequent market returns throughout history.

Two point six five

If you look through market history prior to the valuation bubble that began in the mid-1990's, you will observe only three times that the dividend yield on the S&P 500 dropped to 2.65%. The precise dates should be instantly familiar. August 1929, December 1972, and August 1987. These dates represented the peaks prior to the three worst market plunges of the 20th century.

Prior to the mid-1990's, the median dividend yield on the S&P 500 had been about 4.1%. Then, the market launched into what would ultimately become a valuation bubble, followed by a decade of dismal returns for investors. Since then, the dividend yield on the S&P 500 has regularly dipped below 2.65%, and as of last week, had dropped to just 2%.

It is not a theory, but simple algebra, that the total return on the S&P 500 over any period of time can be accurately written in terms of its original yield, its terminal yield, and the growth rate of dividends. Specifically,

Total annual return = (1+g)(Yoriginal/Yterminal)^(1/T) - 1 + (Yoriginal+Yterminal)/2

As it happens, the long-term growth rates of S&P 500 dividends, earnings (measured peak-to-peak across economic cycles) and other fundamentals have been remarkably stable for more than 70 years, at about 6% annually, with very little variation even during the inflationary 1970's. Even if one includes the depressed yields of the bubble period, and restrict history to the post-war period, the median dividend yield is 3.7%. Thus, a reasonably good estimate of future 7-year total returns for the S&P 500 is simply:

Total annual return = (1.06)(Yoriginal/.037)^(1/7) - 1 + (Yoriginal + .037)/2

At a 2% dividend yield, this estimate is currently -0.07%.

For historical perspective, the chart below presents the 7-year projected total returns obtained in this manner in blue. The actual subsequent 7-year total return for the S&P 500 is depicted in green. Notice that the performance of this method deteriorated significantly after about 1988, reflecting the fact that terminal yields 7 years later began to depart dramatically from prior historical norms.

In order to understand the departure of that green line (actual 7-year returns) from the blue line (expected 7-year returns), it is important to recognize the effect of bubble valuations in the period since the mid-1990's. One way to understand this impact is to ask the counterfactual question: what would the actual returns of the S&P 500 been if the dividend yield had not broken below the 2.65% level that defined past historical market peaks?

The answer to that question is depicted below by the red line. It presents actual historical 7-year S&P 500 total returns with one restriction. For 7-year periods that ended at a dividend yield of less than 2.65%, the red line presents what the 7-year return would have been if the terminal yield was limited to a 2.65 lower bound.

The difference between the green line and the red line represents the effect of bubble valuations. Had it not been for a period of sustained bubble valuations (which ultimately proved themselves to be bubble valuations by creating a 13 year period of dismal subsequent returns), we find that the yield-based model above would have extended its admirable historical record.

This creates a terrible problem for investors here. Given that the yield on the S&P 500 is now below 2%, it is essential for investors to recognize that they now rely on the achievement and maintenance of sustained bubble valuations in the years ahead. Unless investors believe that bubble valuations can be maintained indefinitely, they can expect little but abysmal returns over the coming 5- 7 year period.

As I've noted in previous commentaries, one obtains similar results even using forward operating earnings, provided that the model factors in the variation in growth rates that is driven by fluctuations in profit margins. Unlike dividends or Shiller (10-year average) earnings, operating earnings have a larger cyclical component due to expansion and contraction of profit margins. The more variable the fundamental, the more important it is to model variation in the growth rate. Having done that, however, a variety of fundamentals provide very similar long-term return implications. The implications are particularly uninspiring over a 5-7 year horizon, where our total return projections range between 0-3% depending on the fundamental used. The corresponding 10-year projections are in the 3-5% range.

For comparison, I've presented the identical analysis below using Shiller P/E ratios rather than dividend yields. For this version, I've defined bubble valuations as Shiller P/E ratios of 21 and above, which have historically been followed by poor long-term returns.

The implications of Shiller P/E ratios are slightly more constructive than those from dividends. As I noted last week, the ratio of dividends to various earnings measures is somewhat low at present, reflecting outright dividend cuts in recent years, combined with elevated profit margins. Some would also argue that share repurchases should also be counted as dividends, but as the function of share repurchases is largely to offset the dilution that results from option grants to employees and corporate insiders, I strongly disagree. Nevertheless, Shiller earnings are not subject to that debate, and are less sensitive to shorter-term variations, providing a "smoother" fundamental. Our 7-year total return projection for the S&P 500, based on Shiller P/E ratios, is approximately 3% at present. Again, investor expectations for substantially higher returns over the coming years rely on bubble valuations to be maintained and extended indefinitely. This is not impossible, but there is no margin of safety in that requirement.

Economic notes

Citing "imminent funding pressures" in the global banking system, the IMF released a report last week suggesting the potential for a fresh round of bank stress. The primary focus of concern was the European banking system, due to "relatively greater pressure in European banking systems from both sovereign risks and wholesale funding strains," but the IMF indicated that U.S. banks may also need to raise additional capital "to reverse recent deleveraging trends, and possibly to comply with U.S. regulatory reforms." The IMF warned that "Conditions in the global financial system now have the potential of jumping from benign to crisis mode very rapidly."

It will come as no surprise that we agree, but at least for now, investors evidently could not care less. Had investors been correct in ignoring the ultimately disastrous risks of the dot-com bubble, the tech bubble, the housing bubble, and the overleveraging of U.S. financial institutions that preceded the recent credit crisis, we would concede that the market's wisdom on these issues should take precedence over our own concerns. But in our view, those disasters were predictable. Likewise, as noted above, the persistent willingness of investors to misprice stocks is exactly why they have gone nowhere for over a decade. We'd love to be bulls, scampering happily about. But that would be helped if stocks were priced appropriately and if there was not a large anvil suspended on a fraying string overhead.

We strongly believe that price and volume behavior conveys information, but that belief does not extend to the dogma that they do so perfectly, or that prices are "sufficient statistics" for the overall state of the world (which would make analyzing additional data useless). Rather, our view is that the stock market is substantially overvalued here, and that investors continue to be diverted from the big picture by the clown carnival of short-term news and investing-as-sport that is celebrated on financial television.

The global financial system continues to be unsound in the same way that a Ponzi scheme is unsound: there are not enough cash flows to ultimately service the face value of all the existing obligations over time. A Ponzi scheme may very well be liquid, as long as few people ask for their money back at any given time. But solvency is a different matter - relating to the ability of the assets to satisfy the liabilities.

The way you prevent Ponzi schemes is by requiring that assets are audited based on their tradable market value, and that the auditors make certain those assets are actually in custody. Unfortunately, banks are now allowed to value many of their assets with significant judgment, and the models may be no better than the ones that assigned investment-grade ratings to sub-prime loans. Meanwhile, numerous banks have been abruptly suspending foreclosures, because it is increasingly evident that in many cases they do not even have documentation of the underlying mortgages. It is difficult to see how this can possibly inspire confidence that the credit crisis is over and everything is back to normal.

To be clear, I should emphasize that our expectation for poor equity returns over the coming 5-7 years is driven by valuations, not by any particular expectation regarding credit strains or economic pressures. The importance of the economic factors is that they threaten to front-load the longer-term reversion of valuations into the immediate future.

A 5-year return of zero, for example, can be achieved by 5 consecutive returns of zero, or by a 32% decline in a single year followed by four consecutive years with positive returns of 10% each. The argument is not that stocks will perform poorly on a consistent basis for the next 5-7 years. Frankly, I would much prefer a retreat in valuations sooner than later, and with sufficient force to dissuade investors from returning to the unproductive, economy-wrecking, bubble-chasing mentality that has ultimately sabotaged their long-term financial security. In any event, 5-7 years from now, when investors look back at today's investment opportunities, they are unlikely to view them longingly.

Market Climate

As of last week, the Market Climate in stocks was characterized by strenuous overvaluation, overbought, overbullish conditions, and unfavorable economic pressures. This is a combination that has historically been associated with poor returns, on average. As always, our interest is on the average return/risk tradeoff associated with the conditions we observe. For now, we remain defensive. In the Strategic Growth Fund, we remain fully hedged, with a "staggered strike" position where we have raised our put option strikes closer to market levels to defend as strongly as possible against potential market losses. In the Strategic International Equity Fund, the majority of our stock holdings are also hedged with a combination of global indices that are well-correlated with our holdings, including the Dow Jones EuroStoxx Index, the FTSE 100 and the S&P 500. To the extent that we use international futures to hedge, we can hedge the equity risk, the currency fluctuations, or both. Presently, the equity risk is our primary concern. Meanwhile, using the S&P 500 as a hedge covers broad equity risk while leaving some of our currency exposure unhedged, which is intentional.

Last week was a bit uncomfortable for Strategic Growth, as the "risk trade" on hopes about quantitative easing strongly favored aggressive stocks over conservative ones, so our holdings did not participate well in the advance. This happens from time to time. We just stick to our stock selection discipline, which has served us well over the years.

While the S&P 500 has essentially gone nowhere since early January, the present overvalued, overbought and overbullish conditions, coupled with still negative economic pressures, suggests the potential for a familiar pattern of market behavior that I refer to as "unpleasant skew." The short-term tendency in such conditions tends toward small advances to repeated marginal new highs, often followed abruptly by a steep "air pocket" that wipes out weeks or months of progress in the span of a few days. During the interim, however, it's typical for 2-3 day pullbacks to to be followed by spike advances that do little but recover the lost ground, but that make the advance appear relentless. The average of numerous modest gains and a smaller number of steep losses may be negative, and yet, from a frequency perspective, there can be more up-days than down-days. Suffice it to say that we view the prospective return/risk profile of the market here as poor, but that assessment is based on average behavior.

In bonds, the Market Climate last week was characterized by moderately unfavorable yield levels and favorable yield pressures. The Strategic Total Return Fund continues to carry a duration of slightly over 4 years. On significant strength in precious metals and foreign currencies (neatly following the "exchange rate overshooting" argument that I discussed a couple of months ago), we did clip our holdings back, now with about 6% of assets in precious metals shares, about 2% of assets in foreign currencies, and about 2% in utility shares. My impression is not that the weakness in the dollar has fully run its course, but quantitative easing was elevated last week to a near certainty in the minds of investors. My impression is that it is not as certain as investors appear to believe, nor would it have the straightforward benefits that investors seem to assume. More on that next week. For our part, last week's strength was a good enough opportunity to take a bird in the hand on part of our holdings.

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