HIDEOUS OPPORTUNITY SET

John Hussman presents the facts. What you do is up to you.

Fed-induced speculation does not create wealth. It only changes the profile of returns over time. It redistributes wealth away from investors who are enticed to buy at rich valuations and hold the bag, and redistributes wealth toward the handful of investors both fortunate and wise enough to sell at rich valuations and wait for better opportunities. There won’t be many, because rising prices also encourage overconfidence in a permanent ascent. Few investors are capable of enduring the discomfort of being on the sidelines for very long if a speculative market proceeds further without them.

Based on valuation methods that have maintained a near-90% correlation with actual subsequent market returns not only historically but also in recent decades, we presently estimate 10-year nominal total returns for the S&P 500 Index averaging just 2.3% annually. It is worth remembering that these same methods indicated the likelihood of 10-year S&P 500 total returns averaging 10-12% annually in late-2008 and early-2009 (our 2009 insistence on stress-testing against Depression-era data was not based on valuation concerns). Moreover, our current estimates of prospective S&P 500 total returns are negative on every horizon shorter than about 7 years. Meanwhile, corporate bond yields and spreads are near record lows, Treasury bill yields are near zero, and the 10-year Treasury bond yield is just over 2.7%. Our friend James Montier at GMO correctly calls this a “hideous opportunity set.”

To give an indication of how hideous the opportunity set of both short- and long-horizon investors has become as a result of quantitative easing and Fed-induced speculation, the chart below shows the estimated return of a balanced portfolio that assumes an allocation of 20% in Treasury bills, 20% in corporate bonds, 20% in Treasury bonds, and 40% in the S&P 500. We currently estimate that the prospective 10-year return on such a balanced portfolio is now at the lowest level in history, at just over 2% annually. The process of driving security prices higher and prospective long-term returns lower has been greatly satisfying over the short-run. The future will be a mirror image, as it was following other historic speculative episodes.

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