Hussman: US shares are 40% overvalued
John Hussman is out with another good piece this week in which he deconstructs all of the short-termism and technical analysis dominating the talk of market followers in the US. He opens saying:
Perhaps the best way to begin this week’s comment is to note that in decades of market analysis, I can’t remember a time that I’ve heard many analysts quoting some support or resistance level as being "critical" for the market. Some are eyeing the 1040 "neckline" on the S&P 500 "head-and-shoulders" formation. Others are eyeing the downward trendline that connects the April and June peaks for the index. Still others point to the "death cross" between the 50-day and the 200-day moving average, near the 1100 level, as being crucial. Even Richard Russell – who deserves more respect than most – has put the full weight of his analysis, over the near term anyway, on whether or not the Dow Transportation average remains above the closing level of 3792.89. The object of discussion has increasingly turned to the implications of this particular chart formation or that, as if some magic number or another absolves investors from having to think about the big picture.
All of this suggests that this is a "rent, not own" market being driven by technical traders who uniformly and somewhat predictably pile on to the sell side or the buy side when particular levels are hit. Last week, we observed the obligatory rally to prior support, closed a "gap" in the S&P 500 chart from a couple of weeks ago, and kissed the 20-day moving average. Based on this sort of "critical level" chatter, a move above the 1100 level could trigger a powerful but short-lived burst of short-covering on the relief of the "death cross", while a move below 1040, and particularly a break in the Transports below 3792.89, would most probably cause all hell to break loose. Simply put, over the very short term, market fluctuations are likely to be driven by masses of technical traders, nearly all acting on precisely the same signals.
Hussman states – and I believe rightly so – that "the key issue here is the sustainability of these moves." We’ve had a bit of a breakout from oversold levels on the back of some very iffy data in the US. Some of the housing and loan delinquency data have been good. Credit is still contracting. Manufacturing and service sector data have been poor, retail and personal income data were mixed and the jobs data were also poor. Clearly, the economic spurt we witnessed over the past year is sputtering. As I see it, there are two ways the present uptrend is sustainable:
- The rough patch we are experiencing fades and the economy becomes more robust.
- The economy muddles through but corporations continue to sport record profit margins.
Hussman, for his part believes the stock market in the US is 40% overvalued on a fundamental basis. Most analysts predicate their valuation on forward operating earnings i.e. what they expect to happen minus all the bad stuff – like charges. Looking at numbers this way creates two problems. First, future earnings may disappoint (or outperform). Second, operating earnings are always higher than real GAAP net income.
For his part, Hussman says:
When you hear analysts say that the historical average P/E ratio is about 15, you have to recognize that this is the normal P/E based on trailing 12-month earnings after subtracting all writeoffs and other charges. Forward operating earnings are invariably much higher, and it turns out that the comparable historical norm, as I discuss in that 2007 piece, is only about 12. If you exclude the late 1990’s bubble valuations, you get a historical norm closer to 11.5. The 1982 and 1974 market lows occurred at about 6 times estimated forward operating earnings.
If you recall, back in the post-technology bubble days we saw some huge charges from companies like TimeWarner and Vodafone for acquisitions that had to be written down in addition to the bevy of charges that companies take at the end of a business cycle. A more realistic way of viewing earnings and normalized P/E ratios is using cumulative past GAAP earnings times a specific normalized higher P/E multiple. I believe this is something that Jeremy Grantham of GMO does. Hussman also makes my point that profit margins are high by historical standards – and margins are mean reverting unless you believe this time is different.
A final observation is crucial. Current forward operating earnings estimates assume profit margins for the S&P 500 companies that are nearly 50% above their long-term historical norms. While we did observe such profit margins for a brief shining moment in 2007, profit margins are extraordinarily cyclical. Investors will walk themselves over a cliff if they price stocks as if profit margins, going forward, will be dramatically and sustainably higher than U.S. companies achieved in all of market history.
Hussman has a lot more to say about resource misallocation – something I have moaned about. Definitely read the full text linked below. I will point to financial services, real estate, military spending and health care spending in the US as disproportionate as compared to any advanced economy. This misallocation has been masked by an asset-based economy reliant on consumption and ever-higher levels of debt to sustain itself. Time is running out on this mode of economic growth.
Caveat Emptor. This is a renter’s market. The secular bear is still in effect.
Source: Misallocating Resources – John Hussman