'Presently, our own measures are not signaling an imminent recession, but we also disagree with those who completely rule out a recession until 2019 or 2020. Rather, we would continue to monitor the full set of measures that we find – in combination – to be well-correlated with oncoming economic weakness.''As I did in 2000 and 2007, I mean these figures seriously – not as hyperbole, but based on outcomes that would be historically standard, normal, and commonplace given current valuation extremes. At present, we project market losses over the completion of this cycle on the order of -64% for the S&P 500 Index, -57% for the Nasdaq 100 Index, -68% for the Russell 2000 Index, and nearly -69% for the Dow Jones Industrial Average.
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One of the charts that has been making the rounds is a depiction of the cumulative S&P 500 real return, going back to 1871. The chart is usually accompanied by a diagonal trendline that gives the impression that long-term real returns are somehow fixed, that valuations can be ignored, and that passive investing always works out over time. Be careful, because the chart also makes the Great Depression look like a walk in the park, with the 1973-74, 2000-2002, and 2007-2009 collapses appearing as little bumps along the road. Very long periods of time also seem very short when they’re presented on a 147-year chart.
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It’s notable that even using price/record earnings – which is the most optimistic of all possible valuation measures and doesn’t make any downward adjustment at all for elevated profit margins – current valuation levels are higher than 1929, 1972, 2007, or any point in history except the very peak of the dot-com bubble. In my view, investors are setting themselves up for a very, very long period of zero or negative real returns in the stock market. In every market cycle, history has regularly offered better opportunities for long-term investors to embrace market risk.
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Given my tendency, at market extremes, to make preposterous projections that turn out rather well over the complete cycle, some insight into the relationship between price/revenue ratios and subsequent returns may be useful, particularly with respect to various market indices.
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We’ve always emphasized that stocks are a claim on the very long-term stream of cash flows that they will deliver to investors over time. When companies are growing very quickly, investors tend to look backward, and as a result, they often apply very high rates of expected growth to already mature companies. When valuations are already elevated, this practice can be disastrous, as investors discovered in the 2000-2002 collapse that followed the tech bubble.
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Presently, Apple is valued at 5.1% of GDP, Amazon at 4.8%, Alphabet (Google) at 4.6%, Facebook at 3.3%, and Netflix at 0.8% of GDP. That’s a total market capitalization of nearly 20% of GDP across 5 stocks. It’s worth remembering that historically, the pre-bubble norm for market capitalization to GDP, adding up every nonfinancial company in the stock market, was only about 60%. At secular lows like 1974 and 1982, the ratio fell to 30% of GDP – for the entire market.
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This movie has played so many times in the historical data that we’ve practically memorized the lines. Near the end of the tech bubble, I got myself a nice bit of scorn on CNBC after Alan Abelson of Barron’s Magazine published my projections for Cisco, EMC, Sun Microsystems and Oracle – all in the range of about 15-20% of the prices where they had recently changed hands. Those projections actually turned out to be slightly optimistic.
There’s always the hope that this time it’s different.
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With regard to Federal Reserve policy, I’ve shown elsewhere that even large “activist” components of Fed policy have no effect on subsequent output, employment, or inflation, beyond what could be predicted simply from past values of output, employment, and inflation themselves. Put another way, recoveries follow steep economic slack in a largely mean-reverting way, and recessions follow tight economic conditions in a similarly mean-reverting way. Ascribing recoveries and recessions to the Federal Reserve makes very little sense. Likewise, the idea that the Fed “risks” creating an inverted yield curve that will “cause” a recession is hogwash.
The main risk of activist Fed policy is that holding short-term interest rates near zero can encourage speculators to seek higher yields in risky or low-quality assets, encouraging Wall Street to create new “product” to meet that demand, and vastly increasing systemic financial risk. That’s what the Fed did between 2003 and 2007, producing the mortgage bubble and collapse, and it’s what the Fed has done yet again in recent years.
The bottom line is that to the extent that inverted yield curves signal a combination of tight economic capacity (particularly in the labor market) coupled with upward pressures on inflation, they do provide useful information. But inverted yield curves aren’t necessary for recessions, nor are they sufficient to imply immediate risks. The yield curve is a useful symptom of economic conditions. It isn’t a cause.
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Presently, our own measures are not signaling an imminent recession, but we also disagree with those who completely rule out a recession until 2019 or 2020. Rather, we would continue to monitor the full set of measures that we find – in combination – to be well-correlated with oncoming economic weakness.
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Meanwhile, recognize that the current enthusiasm about the economy has built in an enormous amount of likely disappointment. Remember – growth has drivers, and once the drivers reach extremes, it becomes very dangerous to extrapolate past trends. Half of the economic growth we’ve observed since the global financial crisis has been driven by a declining unemployment rate, which recently reached a low of 3.8%. Take away the impact of a falling unemployment rate (which has little scope to continue), and the underlying structural growth rate of the economy – a combination of labor force growth and productivity growth – is only about 1.5% annually.
Allow for a doubling in the rate of productivity we’ve observed in recent years, and the prospect for
sustained real U.S. economic growth is still only about 2%. Yes, we may have a quarter of very strong real GDP growth and there, but remember that the annual growth rates being quoted are simply quarterly growth multiplied by four, not sustained, longer-term growth rates. Even modest one-off factors (such as a spike in energy production in Q2) can drive impressive growth rates on the basis of annualized quarterly figures.
Just as the primary driver of market returns in recent years has been a cyclical move from depressed valuations to the most extreme valuation multiples in history, much of the growth in the U.S. economy since the global financial crisis has been driven by the largest cyclical increase in history in the ratio of civilian employment to the civilian labor force. That’s another way of saying that the growth has been largely driven by a decline in the unemployment rate from 10% to just 3.8%. With both valuations and unemployment at cyclical extremes, the likelihood is that the tailwinds that have driven the market returns and economic growth of recent years will turn into headwinds. As that happens, extrapolating growth, as if it is some sort of entitlement, will be a profound mistake.'
- John P. Hussman, Ph.D.
Extrapolating Growth, July 25, 2018
Context '..the phenomenon of wave after wave of economic ups and downs is ideological in character..'Hallmark of an Economic Ponzi SchemeOur Obsession with Consumption — while Ignoring Saving and Investment — Is a Big Problem'..a replay of the reckless U.S. mortgage Credit episode, only on a much grander global scale.''..assets Bubbles, replete with history's greatest redistribution of wealth.''..to envisage a global crisis beyond the scope of 2008/09..''..to defeat all those ideological forces that are operating in favor of credit expansion.' - Ludwig von Mises(Praxeology) - '..the behaviorist and the experimentalists versus the praxeologists and the philosophers..'