John Hussman: Expect meagre returns in an overvalued market
John Hussman’s latest weekly contribution contends that the market is now extremely overvalued, to the point where long-term returns will likely be low.
As of last week, the S&P 500 nearly matched the richest valuations, on normalized earnings, ever observed prior to 1995. While it is quite true that valuations have been higher for the majority of the period since the late 1990’s, it is equally true that the total return of the S&P 500 over that period has been dismal.
Undeniably, stocks are still “cheap” compared to the record overvaluations of 2000 and 2007. In order buy stocks on that basis, investors must accept the prospect of unsatisfactory long-term returns in any event, but they are free to speculate as long as they are willing to treat 2000 and 2007 as normal, and to rely on the market pressing to even greater overvaluation in order to achieve satisfactory near-term returns.
It is also true, however, that market valuations since 1995 have been distinct outliers from a historical perspective (as are the disappointing overall returns). That does not imply that near-term returns must be negative. While we continue to observe weak sponsorship from a volume perspective, flattening momentum, increasing non-confirmations, and some early pressures in yields and credit spreads, we have not observed sharp internal deteriorations at this point. As a result, it is unclear whether or not investors will continue to speculate for a while. Even so, it is already evident that the longer-term outcome of risk-taking here will almost undoubtedly be unrewarding.
In short, any virtue of stocks here is decidedly speculative. Stocks are overvalued to a level from which uninspiring returns have always followed. That fact is true regardless of whether or not the economy is in a sustainable recovery.
The S&P 500 is currently priced to deliver total returns averaging about 6.1% annually over the coming decade, even assuming that the future trajectory of S&P 500 earnings continues to obey the long-term peak-to-peak growth channel that has characterized earnings for most of the past century. Notably, that 6.1% annual projected return was equaled at the market peaks of the 1960’s, early 1970’s and at the 1987 peak. Lower prospective 10-year returns were only observed during the late 1990’s, which have been followed, not surprisingly, by 10-year returns lower than 6.1% annually. When stocks are overvalued, one does not get to have his cake and eat it too, without getting indigestion later.
His view is that there is an 80% likelihood of a double dip recession which will bring a market plunge with it. Generally speaking, I have been more optimistic about medium term prospects, but I still think a double dip is even money at this stage.
Concerns about a second credit wave drive Hussman’s macro view, not just in commercial real estate where everyone is looking but also in residential real estate where foreclosures have been artificially suppressed by extend and pretend practices. In late October, I pointed to an analysis by Annaly Capital which depicted an increasing disparity between foreclosures and loan delinquencies. I interpreted this to presage another, second wave of foreclosures as does Hussman – a major reason to be bearish on banks and to believe the TARP repayments are premature.
Hussman also quotes Meredith Whitney who shares these same concerns (see video here):
In the second quarter, you had banks recapitalizing themselves with huge equity volumes, you had a lot of write-ups throughout the year, but the core loan books have been declining dramatically, so what’s left? The toxic assets have all been written up. There’s a very limited cash market for them. You would never know about the degradation in asset quality (of loans backed by Fannie Mae) because the government has been buying the paper. The paper has never traded higher. There’s still time (for toxic assets to become a major problem again). They have to because there are not cash flows to support the payments on those bonds, and the bonds will break covenants. What’s happening is that the banks are going to have to start selling stuff, and so you’ll start seeing a yard sale to raise capital.
The full Hussman piece ties a lot of loose ends (long-term stock market returns, housing, bank earnings, credit availability, and economic recovery) together at the link below.
Decidedly Speculative – John Hussman, 14 December 2009, Weekly Market Comment