Stock Market Investment Risk Holds Near All-time High

| April 28, 2014

Our Secular Trend Score (STS) and Cyclical Trend Score (CTS) are calculated using a large basket of fundamental, technical, internal and sentiment data. The historical data used by our models extend back to the market crash in 1929 and have enabled our STS to correctly identify every secular inflection point and our CTS to correctly identify more than 90 percent of all cyclical inflection points during the last 85 years. Additionally, when analyzed collectively, these data identify extremes in the risk/reward profile of the stock market from an investment perspective. Since early 2013, stock market investment risk has remained in the highest one percentile of all historical observations, and the latest speculative surge during the last year has increased overall risk to one of the highest levels ever recorded, joining a select group of three time periods that includes the long-term tops in 1929 and 2000.

As we often stress, this particular measurement of investment risk is not a top call or an indication that a severe market decline is imminent. Overbought rallies such as this one can remain overbought for a long time as speculative momentum carries prices to higher and higher extremes. What the current investment risk/reward profile tells us is that a severe market decline will almost certainly occur after the current cyclical bull market terminates. In his latest weekly commentary, fund manager John Hussman reviews another data set that indicates stock market valuations have now exceeded those at the previous bubble peak in 2000. We have included an excerpt from his commentary below, although we would highly recommend reading the entire article.

At bull market peaks, investors typically fail to recognize cyclically elevated profit margins, assuming that those margins are permanent and that earnings can be taken at face value. If there is one thing that separates our views here from the bulk of Wall Street analysis, it is the historically-informed insistence that investors are mistakenly banking on record-high profit margins to be permanent. For more on this, including evidence that historical profit margin dynamics remain quite on track and have not changed a whit, see The Coming Retreat in Corporate Earnings, and An Open Letter to the FOMC: Recognizing the Valuation Bubble in Equities.

While the evidence may be alarming to some, make no mistake: The median price/revenue multiple for S&P 500 constituents is now significantly higher than at the 2000 market peak. The average price/revenue multiple across S&P 500 constituents is now above every point in that bubble except the first and third quarters of 2000. Only the capitalization-weighted price/revenue multiple – presently at about 1.7 – is materially below the price/revenue multiple of 2.2 reached at the 2000 peak. That’s largely because S&P 500 market capitalization was dominated by high price/revenue technology stocks in 2000. [Geek's Note: as a result, if one chooses a universe of stocks by first sorting by market capitalization, one will probably find that price/revenue multiples of those stocks are lower today than in 2000]. Regardless, the historical norm for the capitalization-weighted S&P 500 price/revenue ratio is only about 0.80, less than half of present levels. The fact is that unless current record-high profit margins turn out to be permanent, against all historical experience to the contrary, the overvaluation of the broad equity market is equal or more extreme today than it was at the 2000 bubble peak.

Bill Hester and Jeff Huber here at Hussman Strategic Advisors compiled the chart below using point-in-time constituents of the S&P 500 Index each quarter since 1990. Investors often forget that smaller stocks struggled during the final years of the bubble as investors clamored for glamour. Again, the broad stock market was much more reasonably valued in 2000 than it is today, as extreme valuations were skewed among the largest of the large caps. Not anymore. The Federal Reserve has stomped on the gas pedal for years, inadvertently taking price/earnings ratios at face value, while attending to “equity risk premium” models that have a demonstrably poor relationship with subsequent returns. As a result, the Fed has produced what is now the most generalized equity valuation bubble that investors are likely to observe in their lifetimes.

As a reminder of where capitalization-weighted valuations stand, the following chart shows the present ratio of market capitalization to GDP (shown on an inverted scale on the left, so richer valuations are lower on the chart). Actual subsequent 10-year S&P 500 total returns are plotted in red (right scale). Any belief that present levels represent a “zone of reasonableness” is detached from the historical evidence. The entire market does not deserve to be viewed as a wide-moat Buffett-type stock where earnings can be relied on as a sufficient statistic of value.

All of this said, I would be remiss if I did not emphasize that valuation is not a timing tool. We have a strong expectation that stocks will achieve weak total returns over the coming decade, and negative total returns over horizons shorter than about 7 years. But as the investment horizon shortens to less than a few years, other factors become more important in determining market returns.

I’ve historically encouraged buy-and-hold investors to maintain their own investment discipline, though with a realistic and historically-informed understanding of prospective return and risk. At present, my concern is that many buy-and-hold investors are unaware of how dismal prospective returns are likely to be from current prices, over every investment horizon of a decade or less. Given the duration of the equity market (which mathematically works out to be roughly the market price/dividend multiple), a passive 100% exposure to equities is appropriate only for investors with a horizon of about 50 years. Passive buy-and-hold investors would be well-advised to scale their equity exposures accordingly, based on their own actual investment horizons. Meanwhile, it seems clear that investors have mentally minimized their concept of potential downside, despite two 50% bear market losses in recent memory that were both accompanied by aggressive Fed easing all the way down.

At present, the picture below is just a monthly chart of the S&P 500 since 1995. Not long from now, perhaps less than 2 or 3 years, many investors will look at the same chart with their head in their hands, asking “What was I thinking?” The central message to investors with unhedged equity positions and investment horizons shorter than about 7 years: Prospective returns have reached zero. The value you seek from selling in the future is already on the table today. The future is now.

We have avoided taking the difficult steps that will ultimately be required to heal our economy and lay the foundation for the next structural growth cycle. Instead, we continue to buy time via short-term measures. Although the recent quantitative easing programs have not meaningfully addressed the structural problems that are weighing on our economy, they have successfully inflated the stock market, creating yet another massive bubble. Unless this time is different, and the fundamental nature of the business cycle has somehow been changed, the current stock market bubble will end as badly as all previous bubbles. It remains to be seen what form the catalyst for the bubble implosion will take, and it is usually something that conventional thought had not been expecting. However, it is not a matter of if the bubble will burst, but when.

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Category: Commentary, Market Update


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