Estimating Downside Market Risk

I realize that the entire tenor of market commentary here is ‘A good investor rides out the storms. Hold for the long term and you’ll be fine.’ The problem is that market participants stopped being investors when they accepted the notion that stocks are always attractive regardless of the price paid for them. Though prices have moved down rapidly, I have not seen much evidence that investors have actually reduced their exposure. Yes, they feel pain, but they’re hoping that the pain will end without the necessity of doing anything. Again, the real problem is that they have no concept of value. They’re looking at how far prices have declined, and have decided that this must be enough. But unless they understand value, they do not realize how much lower prices would have to decline just to attain median historical valuations. Value is not measured by how far prices have declined, but by the relationship between prices and properly discounted cash flows. On that basis, the market could have a deep follow-through ahead. We’ll take our signals as they come.

– John P. Hussman, Ph.D., March 15, 2001

At the beginning of 2022, our most reliable stock market valuation measures stood at record levels, beyond even their 1929 and 2000 extremes. The 10-year Treasury yield was at 1.5%, the 30-year Treasury bond yield was at 1.9%, and Treasury bill yields were just 0.06%. By our estimates, that combination produced the most negative expected return for a conventional passive investment portfolio in U.S. history. Year-to-date through October 14, 2022, the S&P 500 has lost -23.9% including dividends, 10-year Treasury bonds have lost -18.1%, and 30-year Treasury bonds have lost -33.8%.

For any given set of future cash flows, the lower the price an investor pays today, the higher the returns the investor will enjoy in the future. The “good news” is that the declines in stock and bond prices this year have increased the long-term returns investors can expect. The bad news is that the “good news” is likely to get better.

At present, investors in Treasury bonds can at least look forward to earning an average of 4.02% annually over a 10-year horizon, and 3.99% annually over a 30-year horizon. Likewise, year-to-date stock market losses have been sufficient to bring our estimates of 10-12 year S&P 500 total returns from the most negative levels in history to – well, about zero. It’s a start.