THE DISMAL FUTURE HAS ARRIVED

Can zero interest rates permanently keep stock elevated? I guess we’ll find out. I’m sure this time is different from 1929, 2000 and 2007.

The Delusion of Perpetual Motion

John P. Hussman, Ph.D.

“I am definitely concerned. When was [the cyclically adjusted P/E ratio or CAPE] higher than it is now? I can tell you: 1929, 2000 and 2007. Very low interest rates help to explain the high CAPE. That doesn’t mean that the high CAPE isn’t a forecast of bad performance. When I look at interest rates in a forecasting regression with the CAPE, I don’t get much additional benefit from looking at interest rates… We don’t know what it’s going to do. There could be a massive crash, like we saw in 2000 and 2007, the last two times it looked like this. But I don’t know. I think, realistically, stocks should be in someone’s portfolio. Maybe lighten up… One thing though, I don’t know how many people look at plots of the market. If you just look at a plot of one of the major averages in the U.S., you’ll see what look like three peaks – 2000, 2007 and now – it just looks to me like a peak. I’m not saying it is. I would think that there are people thinking – way – it’s gone way up since 2009. It’s likely to turn down again, just like it did the last two times.”

Professor Robert Shiller, June 25, 2014, The Daily Ticker

 “If you examine the full historical record, you’ll find that the relationship between S&P 500 earnings yields and 10-year Treasury yields (or other interest rates for that matter) isn’t tight at all. The further you look back, the weaker the relationship. To a large extent, the relationship we do observe is linked to the single inflation-disinflation cycle that began in the mid-1960’s, hit its peak about 1980, and then gradually reversed course over the next two decades. Still, it’s clear that during the past few decades, however one wishes to explain it, earnings yields and interest rates have had a stronger relationship than they have exhibited historically (though not nearly as strong as the Fed Model implies).

“So why isn’t it correct to say that lower interest rates justify today’s elevated P/E ratios? It’s in the meaning of the word ‘justify’ where things get interesting. To most investors, a justified valuation is the level of prices that would still be likely to deliver a reasonable return. Unless that’s true, being able to explain the price/earnings ratio is not enough to say that it’s a justified valuation. While it’s true that lower yields have been associated with higher P/E ratios in recent decades, the meaning of that for investors isn’t positive or even neutral, it’s decidedly negative. Stocks since 1970 have been heavily sensitive, and possibly overly sensitive, to interest rate swings. While lower interest rates have supported higher P/E ratios, those lower rates and higher P/E ratios, in turn, have been associated with poorer subsequent stock market performance. In short, if investors want to argue that low interest rates help to explain today’s elevated P/E ratios, that’s fine, as long as they also recognize that subsequent returns on stocks are likely to be dismal in the future as a result.”

Explaining isn’t Justifying – Hussman Funds Weekly Market Comment, July 2005*

The central thesis among investors at present is that they are “forced” to hold stocks, given the alternative of zero short-term interest rates and long-term interest rates well below the level of recent decades (though yields were regularly at or below current levels prior to the 1960s, which didn’t stop equities from being regularly priced to achieve long-term returns well above 10% annually). The corollary is that investors seem to believe that as long as interest rates are held near zero, stocks will continue to advance at a positive or even average or above-average rate.

It’s certainly true that from a psychological standpoint, the Federal Reserve has induced the same sort of yield-seeking speculation that drove investors into mortgage securities (in hopes of a “pickup” over depressed Treasury-bill yields), fueled the housing bubble, and resulted in the deepest economic and financial collapse since the Great Depression. This yield-seeking has clearly been a factor in encouraging investors to forget everything they ever learned from finance, history, or even two successive 50% market plunges in little more than a decade.

But the finance of all of this – the relationship between prices, valuations and subsequent investment returns – hasn’t been altered at all. As the price investors pay for a given stream of future cash flows increases, the long-term rate of return that they will achieve on their investment declines. Zero short-term interest rates may “justify” the purchase of stocks at higher valuations so that stocks promise equally dismal future returns. But once stocks reach that point, investors should understand that those dismal future returns will still arrive.

Let me say that again. The Federal Reserve’s promise to hold safe interest rates at zero for a very long period of time has not created a perpetual motion machine for stocks. No – it has simply created an environment where investors have felt forced to speculate, to the point where stocks are now also priced to deliver zero total returns for a very long period of time. Put simply, we are already here.

Based on valuation measures most reliably associated with actual subsequent market returns, we presently estimate negative total returns for the S&P 500 on every horizon of 7 years and less, with 10-year nominal total returns averaging just 1.9% annually.

On a historical basis, the CAPE of over 26 is already quite enough to expect more than a decade of negative real total returns for the S&P 500. Aside from the crashes that followed the 1929, 2000 and 2007 peaks, a very long period of negative real returns also followed the other historical peak in the CAPE near 24 in the mid-1960’s. As noted above, one adjustment to the CAPE that significantly improves its relationship with actual subsequent market returns – as it does for numerous other measures – is to correct for the implied profit margin embedded into the multiple. This is true even though the denominator of the CAPE is based on 10-year averaging. At present, the margin embedded in the Shiller CAPE is more than 20% above the historical average. Adjusting for that embedded profit margin – which, again, produces a historically more reliable indication of actual subsequent S&P 500 total returns – the Shiller CAPE would presently be over 32. That level might make even Professor Shiller question whether stocks should be a material component of portfolios (at least for investors with horizons much shorter than the 50-year average duration of S&P 500 stocks). In any event, even the phrase “lighten up” is problematic for the market if more than a few investors heed that advice.

*Though the S&P 500 would achieve a 33% total return from 2005 to its 2007 peak, the index then lost all of that gain, and then another 40% of its value from there, by the 2009 low. That’s how compounding works – a 25% loss wipes out a 33% gain, but a 55% loss compounds that initial 25% loss with a further 40% loss. In the half-cycle since 2009, valuations have recovered and swollen to place the present instance among a handful of extreme valuation “outliers” in history.

See the entire Hussman Weekly Letter