Fund manager John Hussman looks at stock valuations a few different ways and comes to the same conclusion we have: They’re not cheap. In fact, Hussman actually thinks they’re moderately overvalued.
This doesn’t mean the market will crash, although Hussman thinks there’s a reasonable chance that it will. It just means that this isn’t the opportunity of a lifetime so many idiots keep crowing about on TV.
We estimate that the S&P 500 is currently priced to deliver total returns over the next decade in the range of 6.5-9.0%, centered at an expected total return of about 7.8% annually. Stocks are modestly overvalued here, except on metrics that assume a permanent recovery to 2007’s record profit margins (which were about 50% above the historical norm).
On normalized profit margins, sustainable S&P 500 earnings are slightly above $60 on the index. That’s certainly higher than the 7 bucks of net earnings that companies in the index have reported over the past 52 weeks, but unfortunately, even at current prices, the S&P 500 is near 16 times normalized earnings.
What does he mean by “normalized” earnings? The level of earnings US companies would generate at average profit margins.
As Jeremy Grantham likes to say, profit margins are “one of the most dependably mean-reverting series in finance.” When times are good, as they were from 2005-2007, profit margins become unsustainably high. When times are bad, as they are now, margins get unsustainably low.
If you measure your price earnings ratio or earnings power from one of these peaks or valleys, you’ll get a misleading picture of stock value (Just ask all those crowing that the market was cheap in 2007). If, instead, you “normalize” earnings, you’ll get a sense of where stocks are trading relative to a long-term earnings growth trend.
You can get that basic figure [16X earnings] a lot of ways. Currently, book value on the S&P 500 is slightly above $500. Outside of the past 15 years, when the economy was building up to a debt crisis, the typical return on equity for the S&P 500 has historically ranged between about 10-12%. While a higher debt load raises return on equity in good times, it also leads more quickly to bankruptcy in bad times, as we’ve observed, and will continue to observe. The deleveraging pressure on the U.S. and global economy here is likely to be associated with a normalization in return-on-equity just as we’re observing a normalization in profit margins (return on revenue, so to speak). Applying the higher end of historical return on equity to current book value, and assuming that we don’t see major further writedowns in book value for the index, we again get a normalized earnings figure close to about $60. Again, the higher earnings figures (over $80) that we observed in 2007 were based on profit margins and returns on equity far above the historical norm, and were also bolstered by unusual contributions from financials and commodity-driven companies.
Presently, the price-to-book ratio on the S&P 500 is about 1.9. If you think about the 1974 and 1982 lows, we observed price/book ratios at about 0.8, while price-to-normalized earnings multiples were at about 7. So the S&P 500 would have to drop by about 60% to match the best valuations that we’ve seen during the past 40 years. Investors shouldn’t kid themselves that stocks are cheap – in the sense of being priced to deliver outstanding long-term returns – just because we’ve observed a wicked decline. We’re not even close.
At the March lows, the S&P 500 was priced to deliver long-term returns in the 10-12% range. Certainly not bad, but only modestly above the norm on a historical basis, in an economy that faced (and still threatens to suffer) difficulties well outside the norm. While that might have been the final low, and we can’t rule out further market gains, I still believe that it is a mistake to rule out eventual “revulsion.” I don’t think that we need to match valuations that existed at the 1974 or 1982 lows, but at a multiple of 16 times our current estimate for normalized earnings, suffice it to say that the market is not cheap.
In the current environment and economy, Hussman thinks there’s a lot more downside than upside. Read his full letter here >