In his latest weekly note, John Hussman highlights last week’s muni bond plunge, and warns of a coming cliff dive:
Last week, the return/risk profiles that we estimate for stocks, bonds and even gold declined abruptly, based on the metrics we track. We don’t know how long this shift will persist, but at present, investment risk appears to have spiked considerably, and our estimates of prospective market returns have deteriorated. The abruptness of the shift in market conditions is exemplified by the weakness observed in Irish, Greek and Spanish debt, as well as the plunge in municipal bonds (particularly, as Barry Ritholtz observes, in CA issues – see the chart below), which was steep enough to erase nearly a full year of progress in just three days.
On the NYSE, hundreds of stocks achieved new 52-week highs, but ended down on the week, with technical evidence suggesting a uniform reversal from a “high pole” buying climax. The percentage of bullish investment advisors reached 48.4% – the highest since the April peak, while the AAII sentiment poll shot to 57.6% bulls – the highest since 2007. Our bond market measures shifted to an unfavorable status for yield pressures, putting the stock market in an overvalued, overbought, overbullish, rising-yields conformation despite QE2, which as anticipated, has been met with fairly eager offers from bondholders.
Whenever one evaluates market conditions, the entire context matters. Various economic and market indicators provide only partial views – much like the group of blind men who identified an elephant as a snake, a spear, a fan, a tree, a wall, and a rope, depending which part they touched. While various positive indicators can be identified, what matters to us is the full context. In stocks, we have overvalued, overbought, overbullish, rising yield conditions. In bonds, we have unfavorable yield levels and now unfavorable yield pressures. In precious metals, conditions are mixed, so the negative overall conditions in that market at present are somewhat more subtle and may be short-lived.
I don’t want to make a fanfare of these concerns. They are simply the average implications we observe based on historical market relationships – even in post-war data. Longer-term, based on our standard methodology, we estimate that the S&P 500 is priced to achieve sub-5% returns, albeit with significant risk, for every horizon out to a decade. Treasury securities are clearly priced to deliver similarly low returns. It’s possible that internals will improve sufficiently to shift the expected return/risk profiles we observe in stocks, bonds and precious metals. For now, we are tightly defensive.
As for equities:
The chart below underscores the relationship between high current profit margins and poor subsequent earnings growth. The blue line shows U.S. corporate profits as a percentage of GDP (left scale), which is currently just over 8% and at the highest level since 2007. The red line depicts subsequent 5-year growth in profits, but on an inverted right scale (higher values are more negative). In effect, it should not be a surprise if present levels of corporate profits are followed by negative profit growth over the coming 5 years. Indeed, the 2009 burst of stimulus spending is most probably the only factor that has prevented profit growth from being negative over the most recent 5-year period.
Municipal bond investors are clearly re-evaluating the prospects for additional fiscal stimulus from the federal government. Indeed, many state and local governments (as well as health and disability service providers that benefited from stimulus dollars), are beginning to talk about “the cliff” – an abrupt reduction in revenues due to the loss of current stimulus funding which has been used to bridge existing budget shortfalls. My impression is that equity investors face a similar “cliff” which they may not have adequately recognised yet.
The essential point is that stocks are much more richly valued than simplistic P/E multiples would suggest. Investors may pay a heavy price if they fail to adjust valuations for the level of profit margins. The only proper way to value stocks is in relation to measures of sustainable, long-run, full-cycle financial performance.