Excerpted from Hussman Funds Market Comment
Based on valuation metrics that have demonstrated a near-90% correlation with subsequent 10-year S&P 500 total returns, not only historically but also in recent decades, we estimate that U.S. equities are more than 100% above the level that would be associated with historically normal future returns. We presently estimate 10-year nominal total returns for the S&P 500 averaging just 2.2% annually over the coming decade, with zero or negative nominal total returns on every horizon of less than 7 years. Regardless of very short-term market direction, it is urgent for investors to understand where the equity markets are positioned in the context of the full cycle.
It is the series of extreme instances over the past year that give investors the hope and delusion that historically reckless market conditions will lead only to further gains and greater highs. This is a mistake born of complacency in the face of a nearly uninterrupted, Fed-enabled 5-year market advance, and is the same mistake that was made in 2000 and again in 2007. By the time the present market cycle is completed, we expect the S&P 500 to be at least 40% lower than present levels. Only the reliance on historically unreliable valuation metrics, and what Galbraith called the “extreme brevity of financial memory” makes that assertion seem the least bit controversial.
Investors and policy-makers that focus attention on some alternative valuation measure (usually because it seems pleasantly benign) would be well-advised to examine the data, and compare the historical relationship between competing measures and actual subsequent market returns.
It is incorrect to believe that the 2008-2009 market plunge and financial crisis were caused by the housing bubble. The housing bubble was merely the expression of a very specific underlying dynamic. The true cause of that episode can be found earlier, in Federal Reserve policies that suppressed short-term interest rates following the 2000-2002 recession, and provoked a multi-year speculative “reach for yield” into mortgage securities. Wall Street was quite happy to supply the desired “product” to investors who – observing that the housing market had never experienced major losses – misinvested trillions of dollars of savings, chasing mortgage securities and financing a speculative bubble. Of course, the only way to generate enough “product” was to make mortgage loans of progressively lower quality to anyone with a pulse. To believe that the housing bubble caused the crash was is to ignore its origin in Federal Reserve policies that forced investors to reach for yield.
Tragically, the Federal Reserve has done the same thing again – starving investors of safe returns, and promoting a reach for yield into increasingly elevated and speculative assets. Thinking about the crisis only from the perspective of housing, investors and policy-makers have allowed the same process to play out more broadly in the equity market.
On a quantitative basis, the overvaluation of the equity market is greater percentage-wise, and greater dollar-wise, than the overvaluation of housing in 2006-2007. We fully expect that from present valuations, U.S. stocks will produce zero or negative returns on every horizon shorter than 7 years.
There is no antidote or alchemy that will allow a buy-and-hold approach to squeeze water from this stone.
There is no painless monetary fix that will shift the allocation of capital toward productive investment and away from distortive speculation.
Instead, one must wait for the rain. Impatient, crowd-following investors are all too willing to wastefully scatter seeds onto this parched desert, thinking that this is their only chance to sow. To wait patiently in the expectation of fertile soil and rain is not an act of pessimism, but an act of optimism and informed experience.
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