'The most reliable measures of valuation we identify are now between 2.6 and 3.0 times their pre-bubble historical norms..''One fact often lost on investors during a bubble is that a security is nothing but a claim on the very, very long-term stream of cash flows that will be delivered into the hands of investors over time. A valuation ratio is nothing more than a shorthand for a proper discounted cash flow analysis. So whenever one measures valuation using the ratio of price to some fundamental, the essential requirement is that the “fundamental” one chooses must be representative of that very, very long-term stream of future cash flows.
While earnings are certainly necessary to generate those cash flows over time, current and “forward” earnings have historically been very poor “sufficient statistics” for those long-term cash flows. If we examine a wide range of alternatives across history, we actually find that – for the market in aggregate – revenues are far better “sufficient statistics” than earnings. Having detailed this at length, across a century of U.S. data, please see my prior market comments for the extensive evidence on this point.
The chart below shows the ratio of nonfinancial market capitalization to corporate gross value-added, including estimated foreign revenues. I created this measure in 2015 as a better-performing and apples to-apples refinement of market capitalization/GDP, which Warren Buffett discussed in 2001 as “probably the best single measure of where valuations stand at any given moment.” We find Nonfinancial MarketCap/GVA to be more strongly correlated with actual subsequent S&P 500 total returns across history, and even in recent market cycles, than any other valuation measure we have studied or introduced. These other measures include price/earnings, price/forward operating earnings, the Fed Model, Tobin’s Q, and Robert Shiller’s cyclically-adjusted P/E, among others.
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The most reliable measures of valuation we identify are now between 2.6 and 3.0 times their pre-bubble historical norms. No market cycle in history, not even in recent decades, has ended without bringing those measures within 20-40% of those norms (and usually below them). This implies that even a run-of-the-mill completion to the present market cycle can be expected to take the S&P 500 between 45% and 65% lower, even without breaking below historical valuation norms. Likewise, I fully expect that even after dividends, the total return of the S&P 500 over the coming 12-year period will be negative.
Recall that the S&P 500 registered negative total returns for a buy-and-hold strategy during the nearly 12-year period from March 2000 until November 2011. I expect a similar consequence to emerge from current extremes. While investors seem eager to lock themselves into passive strategies that have performed well in the rear-view mirror of this extended climb to obscene valuations, I expect the greatest asset to investors in the coming decade will be adherence to a flexible approach that reduces risk in response to extreme valuation and divergent market action, and embraces risk in response to material retreats in valuation that are coupled with improvements in the uniformity of market action.
I recently observed in our Semi-Annual Report:
“By the completion of this market cycle, I doubt that there will be much talk of the ‘cost’ of getting out too early. The 2000-2002 collapse wiped out the entire total return of the S&P 500 – in excess of Treasury bill returns – all the way back to May 1996. The 2007-2009 collapse wiped out the entire total return of the S&P 500 – in excess of Treasury bill returns – all the way back to June 1995. We correctly anticipated the extent of both collapses. Frankly, I expect that the completion of the current cycle will wipe out the entire total return of the S&P 500 – in excess of Treasury bills – all the way back to roughly October 1997. That outcome would not even require our most reliable measures of valuation to revisit their historical norms. If there is something in the financial markets to be particularly optimistic about, it is the prospect of opportunities that will evolve over the completion of the current market cycle. The strongest expected market return/risk classifications we identify emerge when a material retreat in valuations is joined by an improvement in market action.”
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You’ll often hear risk being equated with return on financial television. The proposition takes various forms. “Higher risk means higher return” or “Well, you can only expect higher returns by taking more risk.” In my view, the idea that higher risk means higher expected return is one of the most dangerous and misunderstood propositions in the financial markets. The reason it’s dangerous is that it ignores the central condition: “provided that one is choosing between portfolios that all maximize expected return per unit of risk.”
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The strongest expected market return/risk classifications we identify emerge when a material retreat in valuations is coupled with an improvement in market action. We don’t require valuations to retreat to their historical norms, or even near them, to justify an exposure to the stock market. But here and now, even patient investors with very long horizons are positioned for disappointment, in my view. Accepting greater risk as a strategy to seek greater returns assumes that one is holding an optimal portfolio. Presently, I don’t believe that a conventional, passive investment mix qualifies. That will change as market conditions do, and we’re well prepared to embrace those opportunities.'
- John P. Hussman, Ph.D.,
The Arithmetic of Risk, March 2, 2018
Context(Global - 2018) - '..manifestations of Monetary Disorder..'The Dangerous Delusion of Price Stability - William White'..Central bankers reflated a deeply unsound financial structure..' - Doug Noland