In his most recent commentary, GMO’s Jeremy Grantham said value investors are destined to endure pain in a market bubble, especially in its latter stages, as clients scorn them for missed opportunities. John Hussman is surely one such investor – indeed, Grantham’s commentary drew extensively on Hussman’s research. In a recent talk, Hussman explained why he, Grantham and other long-term value-driven investors should be worried, even if equity markets perform well in the short run.
“Investors who hope to capture the last throes of a bull market don’t realize how quickly they will lose that on the way down,” Hussman said.
Reversion to the mean will cause equity prices to fall — countless observers have used metrics such as the Shiller cyclically adjusted price-to-earnings ratio (CAPE) or Tobin’s Q ratio to explain this. But Hussman went beyond that, providing a model that improves on conventional ways of predicting market prices. He offered some predictions as to when the correction will occur.
Hussman spoke on May 2 at the second annual Wine Country Conference in Sonoma, sponsored by Sitka Pacific Capital Management. This event has turned into one of the best opportunities to engage with top-tier speakers in an intimate setting – and to enjoy one of the best locations of any conference you’re likely to attend. All proceeds from this year’s event were donated to the Autism Society of America, and I encourage readers to consider this worthwhile cause.
A copy of Hussman’s presentation is available here.
Let’s look at Hussman’s explanation of how reversion to the mean operates and what prospective equity-returns investors are likely to obtain over various time frames.
The dynamics behind mean reversion
Hussman offered a detailed explanation of the mathematics behind mean reversion but said one only needs to answer a simple question to determine whether a variable – such as equity prices – is mean reverting. Let’s assume there is another fundamental variable (e.g., the market-capitalization-to-GDP ratio) that is representative of the mean. Are future changes in one variable (equity prices) inversely correlated with the current level of the fundamental variable (market-cap-to-GDP)?
In the case of equity prices, a high level of market-capitalization-to-GDP ratio is correlated with poor subsequent stock-market returns, and vice versa. That assures that equity prices and stock-market returns mean-revert.
Hussman provided the historical examples to validate this assertion – data which will be very familiar to readers of his weekly market commentaries. Low market-capitalization-to-GDP ratios in the 1950s predicted high returns over the subsequent 30 years, and high ratios in 2000 predicted the poor returns equity investors suffered in the decade following the dot-com boom.
Market-capitalization-to-GDP is but one example of variables that can be used to test mean reversion in stock prices. Whether you use profit margins, corporate taxes, corporate earnings-over-revenues or a similar metric, Hussman said, you get the same result. “Mean reversion hasn’t broken.”
He provided one interesting piece of analysis that I hadn’t seen before. It turns out that, by combining two variables, one can use mean reversion to make more accurate predictions of equity prices than one could make with a single variable.
Earnings alone are “fairly lousy” at predicting stock returns over 10-year time horizons, Hussman said, but if you combine them with profit margins, accuracy improves greatly. This is illustrated in the three-dimensional graph from Hussman’s presentation:
If you were to look at this graph from either the x-axis (profit margins) or the y-axis (price-to-earnings ratios), the points would be scattered and the correlation to the vertical z-axis (subsequent 10-year S&P 500 returns) would be low. But when both the x- and y-axis data are viewed together in three dimensions, the fit is very tight.
What does this mean, as a practical matter? Hussman said that the Shiller CAPE “isn’t a really great valuation measure by itself, but if you take into account the implied profit margin, it becomes an extraordinarily good measure.” Unadjusted, the Shiller CAPE is now at 25, which is high, but not extraordinarily so. But if you adjust that for the embedded level of profit margins, Hussman said, the value is closer to 30.
“You’re actually looking at a Shiller CAPE right now that’s very high, and this is not a pretty level of prospective long-term returns,” he said.
Hussman was asked whether today’s valuations – at an unadjusted Shiller CAPE ratio of 25 – could be a “new normal,” reflecting profit margins and earnings permanently higher than have historically been the case. That paradigm could be true, Hussman said, but only if you also believed that the “new normal” long-term stock returns were 2% or 3% annually, instead of their nearly 10% historical values.
“For people who actually want to make that case, I have no argument against the math,” he said. “I do have a question whether investors are fully aware that they’ve priced securities, especially equities, to return only 2% or 3% annually over the next decade.”
Hussman also dismissed the argument that even though profit margins might decline over the next couple of the years, stocks prices will remain elevated because they are a claim against cash flows long into the future. According to Hussman, stocks have an effective duration of approximately 50, so even a small drop in margins and earnings will trigger a large drop in prices.
How soon will equity prices revert?
Hussman’s logic is eminently persuasive – and consistent with the sentiment of all but the perma-bull market observers. But the problem is that he and many others have been sounding the high-valuation alarm for several years, while equity prices have climbed progressively higher.
Hussman’s model shows that two-year returns on the S&P 500 will be approximately -20%, and if full mean-reversion were to occur, stocks would lose half their value.
But Hussman doesn’t expect that to occur.
“There’s too much variation in two-year returns,” he said. “Valuations are not a timing tool. If you’re a value investor, you’ve got to be prepared to take heat for a long time, because mean reversion does not happen overnight.”
When does Hussman predict mean reversion will occur?
One clue to the answer comes from the Kalecki equation, which I wrote about previously. Essentially, that equation says deficits and surpluses in the private and public sectors must equal one another. One of the reasons profits have been high, as have private-sector surpluses, is that the public sector – the government – had been running large deficits.
But the federal deficit has been shrinking for about a year. I asked Hussman why this hasn’t yet translated to lower corporate profits.
“That erosion will come,” he said, “but it may take a few years.”
The reason gets into technical details. To use the Kalecki equation on U.S. data, you must also consider investment, foreign savings and the net impact on our current account. There is a lag effect. Based on historical data, it takes about six quarters before changes in the public sector show up in the private sector. Hussman said that he’s more worried about those changes showing up in 2015 than he is for the next quarter or so.
The other clue comes from Hussman’s model and how well it predicts returns over various time horizons.
Its predictability improves over longer time horizons. The fit is much closer looking out seven or more years. By the time you get to 15 years, prospective returns on stocks are approximately 4.4%.
But that doesn’t mean you shouldn’t buy stocks for the next 15 years, Hussman said. A decline in prices over the next couple of months or years could “dramatically change things.”
When you go out 20 years, the prospective return improves to 5.5%. What’s going on is that, as you lengthen the time horizon, the expected range of error narrows. There is also an embedded assumption of 6.3% nominal GDP growth, which lifts returns over longer time horizons. But Hussman said there is also noise in the 20-year data (he called it “off-phase behavior”), which makes those forecasts less reliable.
Hussman’s advice
Investors are not doomed to long-term sentence of dismal returns, according to Hussman, nor should they exit the equity markets. “This is basically advice to be cautious at these levels, because history is not on the side of people who think that they’re going to get strong investment returns from here,” Hussman said.
It won’t take a dramatic fall in equity prices for Hussman to recommend a more aggressive equity allocation. He said he’d like to see “at least reasonable valuations” and “an improvement in market action following that decline.” In regard to the latter point, he said he would look for a “uniformity of trends across securities.”
“My strongest advice is to understand the structure of prospective returns so you have some sense of how valuations and prospective returns go hand-in-hand,” Hussman said. “Have some of those calculations and tools to guide your risk aversion and risk tolerance, based partly on valuations.”
As a final warning, Hussman quoted Benjamin Graham, who wrote in Securities Analysis, “Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of good business conditions.”
Read more articles by Robert Huebscher