John Hussman is bearish on the economy and stocks. He backs up his beliefs with good commentary and a series of charts in Economic Measures Continue to Slow .
Please see the article for some excellent economic charts. Here are a few snips regarding equity returns.
With the S&P; 500 at a Shiller P/E over 21, and our own measures indicating an estimated 10-year total return for the S&P; 500 in the low 5% area, it is clear that investors have priced in a much more robust recovery than we are likely to observe. Our long-term total return estimates are consistent the historical norms based on Shiller P/Es – since 1940, Shiller P/E values above 21 have been associated with annual total returns for the S&P; 500 averaging 5.3% over the following 7 years and 4.9% annually over the following decade.
Dividend payout ratios and operating earnings growth
A note on valuation. A number of observers have suggested that the low level of dividend payouts as a fraction of operating earnings is indicative of strong prospects for reinvestment, which is then extrapolated into assumptions for high rates of future earnings growth. Unfortunately, this argument is problematic on two counts.
First, forward operating earnings are not realized cash flows. As I’ve noted frequently over the years, forward operating earnings represent analyst estimates of the next year’s earnings excluding a whole range of chargeoffs and “extraordinary expenses” as if they do not exist. While operating earnings provide a smoother measure of business performance, they don’t provide a good measure of the cash flows that are actually deliverable to shareholders.
Losses that are booked as “extraordinary” are still losses, and represent the results of bad investments and a consumption of amounts that were previously reported as earnings. Similarly, the portion of earnings used for share buybacks is often expended simply to offset dilution from grants of stock to employees and corporate insiders, and again do not reflect cash that is deliverable to shareholders. In recent years, based on the widening gap between reported operating earnings on one hand, and the sum of dividends and increments to book value on the other, a great deal of what is reported as earnings ends up evaporating as extraordinary losses and share compensation.
The second problem with the low level of dividend payouts, relative to forward operating earnings, is that there is no historical evidence whatsoever that low payouts are accompanied by higher growth in future operating earnings. To the contrary, when dividends are low relative to forward operating earnings, it is a signal that operating earnings are temporarily elevated – typically because of transitory profit margins. As a result, subsequent growth in forward earnings is actually slower than normal over the following decade.
On the latitude for a constructive investment stance
Based on the data that we’ve observed in recent months, my view remains that a fresh downturn in the economy remains a not only a possibility but a likelihood. Little of the economic improvement we’ve observed since 2009 appears intrinsic, but instead appears driven by enormous government interventions that are now trailing off. Still, while I believe that there is a second shoe that has not dropped, I recognize that the full force of government policy is to obscure, stimulate, intervene and borrow in every effort to kick that can down the road. I believe that the unaddressed and unresolved problems relating to debt service, employment conditions and housing are too large for this to be successful, but as we move through the remainder of this year – as I’ve said throughout 2010 – we are gradually assigning greater probability to the “post-1940” dataset. Accordingly, there are developments that could potentially move us to a more constructive position. We don’t observe those at present, but an improvement in economic evidence and a clearing of overbought conditions, leaving market internals intact, would be one configuration that might warrant less defensiveness.
To some extent, I view current market conditions as something of a “Ponzi game” in that valuations appear neither sustainable nor likely to produce acceptably high long-term returns, and speculators increasingly rely on finding a greater fool. As the mathematician John Allen Paulos has observed, “people generally worry only about what happens one or two steps ahead and anticipate being able to get out before a collapse… In countless situations people prepare exclusively for near-term outcomes and don’t look very far ahead. They myopically discount the future at an absurdly steep rate.” Undoubtedly, we have periodically missed returns due to our aversion to risks that rely on the ability to find a “greater fool” in order to get out safely. But it is important to recognize that speculative risks are not a source of durable long-term returns. At a Shiller P/E of 21 and a historical peak-to-peak S&P; 500 earnings growth rate of 6%, a simple reversion to the historical (non-bubble) Shiller norm of 14 would require seven years of earnings growth and yet zero growth in prices. Stocks are not cheap here.
Stocks Not Cheap
I wholeheartedly endorse Hussman’s analysis that suggests stocks are not cheap. I have said the same thing repeatedly all year long, most recently in Analysts Cut S&P; 500 Profits Forecast; Earnings Estimates Still Overly Optimistic; Stocks Not Cheap
Earnings Estimates A Mirage
It’s important to understand why earnings have gone up: Trillions of dollars of stimulus worldwide that is not sustainable. Bank earnings estimates have been inflated by massive extend-and-pretend games encouraged by the Fed with a blind eye from the FASB.
Moreover, the FASB has delayed mark-to-market accounting rules and has still not forced banks to bring SIVs and off-balance-sheet assets back on the books. Those assets are held at inflated values.
Equities only look cheap if you use absurd forward earnings estimates, and ignore future writeoffs and other “one-time” items that seem to have a way of recurring with remarkable regularity.
No Sure Things
Although most are plowing hand-over-fist into the “QE-Trade”, it is a mistake to assume that quantitative easing is a guaranteed play for equities. It’s not. Please see Sure Thing?! for a discussion.
Moreover, QE is not a guaranteed play for the economy either, as noted in Bernanke says Lawmakers Should Consider Rules on Fiscal Limits; Expect Hissy Fit from Krugman; Bernanke Pisses in the Wind
Yet everyday I get emails calling me a “chicken little” or other unprintable names for not recommending everyone plow into equities. I heard the exact same thing in 2006-2007.
However, I have recommended gold continuously since it was $300. I have also recommended treasuries with many attempting to short the things and getting their heads blown off.
Superior Returns Come From Reducing Risk
I see no reason to like equities here, but that does not mean they won’t go up. Indeed they did. However, investors need to understand why equities are rising, the likelihood it continues, and what the risks are, even if short-term traders don’t.
When this rally ends, it is as likely as not to be a steep descent with dip buyers fully conditioned to “buy the dip” all the way down.
Day traders and swing traders seem to think that everyone ought to be hopping in and out of stocks every hour or every week. However, not everyone wants to, or can – for many reasons, trade that way. Money managers in particular are unlikely to trade that way.
It is important to honor your timeframe and trading style, not someone else’s.
Most of those fully invested here were also fully invested in 2008, with disastrous consequences.
In the long haul, superior returns are made by reducing risk, patiently waiting for favorable opportunities to invest. In the meantime, (and although this opinion can change at any time without warning) I am comfortable owning gold and treasuries, and being hedged in equities.
It is far easier to make up for lost opportunities than it is to make up for losses, especially losses that happen while chasing the latest sure thing.
Mike “Mish” Shedlock
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