The Delusion of Perpetual Motion

John Mauldin

Jul 02, 2014

In the club where all stock market investors meet every morning when they wake up, the room occupied by those who don’t understand what is going on” is not as crowded as you might expect. I admit I’m not lonesome – I have plenty of fellow confusees” to talk with – but I am told they are having to add some more space for the growing crowd in the “it’s a bull market and those stupid old bears just don’t get itsection of the club.

This week’s Outside the Box is a selection from two essays written by an old friend of my readers (and my good friend), Dr. John Hussman. His recent work has been rather forceful in pointing out that expectations of total returns from the US market over the next seven to ten years are dismal

That conclusion agrees with work I have done in conjunction with Ed Easterling, with Jeremy Grantham’s posts at GMO, and with the work of Robert Shiller (mentioned below). There are numerous other analysts who approach the market differently, but the general conclusion is this: investors with a five- or ten-year time horizon are going to be very disappointed unless they have some methodology to deal with the risk of a significant market downturn.

It’s fascinating how investors come to forget that markets move in cycles and not in perpetual diagonal lines. As value investor Howard Marks wrote in The Most Important Thing, “Rule number one: most things will prove to be cyclical. Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.”

I was writing in 1999 about secular bear markets. I noted then and in 2003 in Bull’s Eye Investing that it typically takes three significant events to end a secular bear market. We have had two so far in this cycle. The opportunities for stock pickers and traders have been phenomenal. Long-term investors, for their part, have certainly been disappointed. If there is one thing that I believe we can truly know,” it is that long-term future returns are based on the valuations in place when you invest. The relationships between long-term valuations and returns are fundamental in nature. Yes, there are variations in the actual outcomes, but they are rather minor when considered from a long-term perspective.

Let me put it another way as bluntly and forcefully as I can. If you are long” the market today, without an exit strategy or a hedge position, your long-term returns are at major risk. I totally understand that you have to be in the market to participate in the returns. I am not a perma-bear. There are clearly ways to be involved in this market without blindly assuming that it will be what John Hussman calls a perpetual motion machine.

Without a lot of comment, let’s go straight to John’s work. I’m actually going to take excerpts from his most recent essay first, as I think that is the logical way to approach the material. You can read all of his work at www.hussmanfunds.com.

Have a great week. And if your country is still in the World Cup chase, enjoy it while it lasts. It was a fun ride for the US, but the script seems to be turning out as forecast, with Argentina and Brazil working their way through the ranks. Maybe someone can stop those juggernauts; they don’t look that invincible. The race, we are told, is not always to the swift or strong – but that is the way to bet, whether in markets or in fútbol.

Your thinking about cycles analyst,

John Mauldin, Editor
Outside the Box


The Delusion of Perpetual Motion

John P. Hussman, Ph.D.

June 30, 2014



“I am definitely concerned. When was [the cyclically adjusted P/E ratio or CAPE] higher than it is now? I can tell you: 1929, 2000 and 2007. Very low interest rates help to explain the high CAPE

That doesn’t mean that the high CAPE isn’t a forecast of bad performance. When I look at interest rates in a forecasting regression with the CAPE, I don’t get much additional benefit from looking at interest rates… We don’t know what it’s going to do. There could be a massive crash, like we saw in 2000 and 2007, the last two times it looked like this. But I don’t know. I think, realistically, stocks should be in someone’s portfolio. Maybe lighten upOne thing though, I don’t know how many people look at plots of the market. If you just look at a plot of one of the major averages in the U.S., you’ll see what look like three peaks2000, 2007 and now it just looks to me like a peak. I´m not saying it is

I would think that there are people thinkingwayit’s gone way up since 2009. It’s likely to turn down again, just like it did the last two times.”

Professor Robert Shiller, June 25, 2014, The Daily Ticker

The central thesis among investors at present is that they have no other choice but to hold stocks, given the alternative of zero short-term interest rates and long-term interest rates well below the level of recent decades (though yields were regularly at or below current levels prior to the 1960s, which didn’t stop equities from being regularly priced to achieve long-term returns well above 10% annually). In this environment, many analysts have argued that elevated stock market valuations are “justified” by the depressed level of interest rates. As I observed the last time around (see Explaining isn’t Justifying):

If you examine the full historical record, you’ll find that the relationship between S&P 500 earnings yields and 10-year Treasury yields (or other interest rates for that matter) isn’t tight at all. The further you look back, the weaker the relationship. To a large extent, the relationship we do observe is linked to the single inflation-disinflation cycle that began in the mid-1960’s, hit its peak about 1980, and then gradually reversed course over the next two decades. Still, it’s clear that during the past few decades, however one wishes to explain it, earnings yields and interest rates have had a stronger relationship than they have exhibited historically (though not nearly as strong as the Fed Model implies).

So why isn’t it correct to say that lower interest rates justify today’s elevated P/E ratios? It’s in the meaning of the word justifywhere things get interesting. To most investors, a justified valuation is the level of prices that would still be likely to deliver a reasonable return. Unless that’s true, being able to explain the price/earnings ratio is not enough to say that it’s a justified valuation. While it’s true that lower yields have been associated with higher P/E ratios in recent decades, the meaning of that for investors isn’t positive or even neutral, it’s decidedly negative. Stocks since 1970 have been heavily sensitive, and possibly overly sensitive, to interest rate swings. While lower interest rates have supported higher P/E ratios, those lower rates and higher P/E ratios, in turn, have been associated with poorer subsequent stock market performance. In short, if investors want to argue that low interest rates help to explain today’s elevated P/E ratios, that’s fine, as long as they also recognize that subsequent returns on stocks are likely to be dismal in the future as a result.

The corollary to the belief that zero interest ratesjustifyelevated valuations is that investors seem to believe that as long as interest rates are held near zero, stocks will continue to advance at a positive or even average or above-average rate.

It’s certainly true that from a psychological standpoint, the Federal Reserve has induced the same sort of yield-seeking speculation that drove investors into mortgage securities (in hopes of a “pickupover depressed Treasury-bill yields), fueled the housing bubble, and resulted in the deepest economic and financial collapse since the Great Depression. This yield-seeking has clearly been a factor in encouraging investors to forget everything they ever learned from finance, history, or even two successive 50% market plunges in little more than a decade.

But the finance of all of this – the relationship between prices, valuations and subsequent investment returns hasn’t been altered at all. As the price investors pay for a given stream of future cash flows increases, the long-term rate of return that they will achieve on their investment declines. Zero short-term interest rates may “justify” the purchase of stocks at higher valuations so that stocks promise equally dismal future returns. But once stocks reach that point, investors should understand that those dismal future returns will still arrive.

Let me say that again. The Federal Reserve’s promise to hold safe interest rates at zero for a very long period of time has not created a perpetual motion machine for stocks. No – it has simply created an environment where investors have felt forced to speculate, to the point where stocksdespite their dramatically greater risk – are now also priced to deliver zero total returns for a very long period of time. Put simply, we are already here.

Based on valuation measures most reliably associated with actual subsequent market returns, we presently estimate negative total returns for the S&P 500 on every horizon of 7 years and less, with 10-year nominal total returns averaging just 1.9% annually. I should note that in real-time, the same valuation approach allowed us to identify the 2000 and 2007 extremes, provided latitude for us to shift to a constructive stance near the start of the intervening bull market in 2003, and indicated the shift to undervaluation in late 2008 and 2009 (see Setting the Record Straight).

I should also note that despite challenges since 2009 related to my insistence on stress-testing against Depression-era data, our valuation methods haven’t missed a beat, and we’ve used the same general approach for decades now. Criticize my fiduciary stress-testing inclinations in response to the credit crisis (which we correctly anticipated). Decry the as-yet uncorrected persistence of extreme overvalued, overbought, overbullish syndromes in recent half-cycle, far longer than they have persisted historically. But don’t imagine that these objections will make the total returns of the S&P 500 any better than zero over the coming years

I’m convinced that we’ve addressed the challenges we confronted in the half-cycle since 2009. No doubt, a further diagonal and uncorrected advance would make us no more constructive than we are at present. Still, one might want to review how our approach served us over complete market cycles prior to this speculative episode

We certainly expect that the next 7-10 years will include a separate bull market, or even two. So there will undoubtedly be strong investment opportunities along the way, but not at these prices. My impression from history is that the completion of the present market cycle will begin with a panic, and end with yet another.

If we examine data since 1940, the 10-year total return on the S&P 500 has a correlation of about 83% with the CAPE. Including the profit margin embedded in the CAPE as an additional explanatory variable brings this correlation to about 90% (to understand why, see Margins, Multiples, and the Iron Law of Valuation). As Shiller correctly observes, including Treasury bill and 10-year Treasury bond yields as additional variables adds no further explanatory power. Put another way, interest rates do have an impact on the level of valuations, but the resulting valuations are informativeat face value – about the probable level of future market returns.

On a historical basis, the CAPE of over 26 is already quite enough to expect more than a decade of negative real total returns for the S&P 500. Aside from the crashes that followed the 1929, 2000 and 2007 peaks, a very long period of negative real returns also followed the other historical peak in the CAPE near 24 in the mid-1960’s. As noted above, one adjustment to the CAPE that significantly improves its relationship with actual subsequent market returns – as it does for numerous other measures – is to correct for the implied profit margin embedded into the multiple

This is true even though the denominator of the CAPE is based on 10-year averaging. At present, the margin embedded in the Shiller CAPE is more than 20% above the historical average. Adjusting for that embedded profit margin – which, again, produces a historically more reliable indication of actual subsequent S&P 500 total returns – the Shiller CAPE would presently be over 32. That level might make even Professor Shiller question whether stocks should be a material component of portfolios (at least for investors with horizons much shorter than the 50-year average duration of S&P 500 stocks). In any event, even the phraselighten up” is problematic for the market if more than a few investors heed that advice.

The ratio of non-financial equity market capitalization to GDP (which has maintained a tight correlation with subsequent 10-year S&P 500 total returns even in recent times) is now about 134%, compared with a pre-bubble norm of 55%. The median price/revenue ratio S&P 500 components easily exceeds, and the average rivals, the levels observed at the 2000 peak. All of this suggests that investors may not appreciate the extent of present overvaluation, lulled once again by the assumption that cyclically-elevated earnings are permanent. Benjamin Graham warned long ago that this assumption is probably the chief source of losses to investors: “The purchasers view the good current earnings as equivalent to ‘earning power’ and assume that prosperity is equivalent to safety.”

Meanwhile, Fed Governor James Bullard observed last week that even the Fed is not inclined to maintain zero interest rate policy indefinitely: “Investors should be listening to the Committee. Of course, you can do what you want.”



Market Peaks Are a Process

John P. Hussman, Ph.D.

June 2, 2014



Regardless of very short-term market direction, it is urgent for investors to understand where the equity markets are positioned in the context of the full market cycle. While the most extreme overvalued, overbought, overbullish, rising-yield syndrome we define has generally appeared only at the most wicked market peaks in history, investors have ignored those conditions over the past year. We can’t be certain when the deferred consequences will emerge. But a century of market history provides strong reason to believe that any intervening gains will be wiped out in spades.

It’s instructive that the 2000-2002 decline wiped out the entire total return of the S&P 500 – in excess of Treasury bills all the way back to May 1996, while the 2007-2009 decline wiped out the entire excess return of the S&P 500 all the way back to June 1995. Overconfidence and overvaluation always extract a terrible payback.

“It may also be helpful to remember that market peaks are a process, not an event. In the presence of a broad range of reliable valuation metrics uniformly at more than twice their historical norms, coupled with the most severe overvalued, overbought, overbullish, rising-yield syndrome we define, it is instructive how shorter-term action has evolved near those points. Outside of today and 1929, the other two instances are, not surprisingly, 2000 and 2007. The chart below provides a more granular reminder that market peaks are often a broad process and can involve hard initial downturns and swift recoveries. The ultimate follow-through provides some insight regarding the full scale of our concerns.”

It is Informed Optimism To Wait for the Rain – Hussman Weekly Market Comment 3/10/14


I should emphasize that the circled areas on the chart above aren’t chosen arbitrarily but reflect points where similar overvalued, overbought, overbullish extremes were observed. As I’ve noted in recent weeks (see The Journeys of Sisyphus and Exit Strategy), depending on how tightly we define this syndrome the 1972 and 1987 peaks can also be captured among the set of extremes that include 1929, 2000, 2007 and today

Remember that at a fine resolution, the full syndrome sometimes doesn’t precisely align with the final market high. Still, we remain convinced that any near term continuation we observe in this advance is likely to appear quite insignificant in the context of what the market loses over the completion of the cycle.

It’s fascinating how investors come to forget that markets move in cycles and not perpetual diagonal lines. As value investor Howard Marks wrote in The Most Important Thing, “Rule number one: most things will prove to be cyclical. Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.” A normal, run-of-the mill cyclical bear market wipes out more than half of the preceding bull market advance. We should not be surprised at all to see the S&P 500 back at 2010 levels or below over the completion of the present cycle. From a valuation standpoint, we estimate that the S&P 500 Index would have to fall to the 1000 level to bring prospective 10-year nominal total returns toward their historical norm of about 10% annually. With the exception of the 2000-2002 bear market, valuations have typically been lower, and prospective returns higher, at cyclical troughs throughout recorded history (even in data prior to the 1960’s when interest rates were similarly depressed).

Not that we need to forecast such an outcome, and certainly not that we would require anything near historical valuation norms to encourage a constructive stance, provided support from other factors. As always, the strongest prospective market return/risk profile is associated with a material retreat in valuations followed by an early improvement in broad measures of market internals.


Central Bankers, Worried About Bubbles, Rebuke Markets

By JACK EWING

JUNE 29, 2014
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Photo A shopkeeper in Lamu, Kenya. A report cautioned on the debt rising in emerging markets. Credit Dai Kurokawa/European Pressphoto Agency


FRANKFURT An organization representing the world’s main central banks warned on Sunday that dangerous new asset bubbles were forming even before the global economy has finished recovering from the last round of financial excess.

Investors, desperate to earn returns when official interest rates are at or near record lows, have been driving up the prices of stocks and other assets with little regard for risk, the Bank for International Settlements in Basel, Switzerland, said in its annual report published on Sunday.

Recovery from the financial crisis that began in 2007 could take several more years, Jaime Caruana, the general manager of the B.I.S., said at the organization’s annual meeting in Basel on Sunday. The recovery could be especially slow in Europe, he said, because debt levels remain high.

During the boom, resources were misallocated on a huge scale,” Mr. Caruana said, according to a text of his speech, “and it will take time to move them to new and more productive uses.”

The B.I.S. provides financial services to national central banks and also acts as a setting where central bankers can discuss monetary policy and other issues like financial stability or bank regulation. The board of directors includes Janet L. Yellen, chairwoman of the Federal Reserve; Mario Draghi, president of the European Central Bank; and the heads of central banks from Japan, China, India and many other countries.

The organization, which reflects a widespread view among central bankers that they are bearing more than their share of the burden of fixing the global economy, often uses its annual reports to send a message to political leaders, commercial bankers and investors. But the B.I.S.’s language in the 2014 edition was unusually direct, as was its warning that the world could be hurtling toward a new crisis.

“There is a disappointing element of déjà vu in all this,” Claudio Borio, head of the monetary and economic department at the B.I.S., said in an interview ahead of Sunday’s release of the report.
He described the reportas a call to action.”

The organization said governments should do more to improve the performance of their economies, such as reducing restrictions on hiring and firing. The report also urged banks to raise more capital as a cushion against risk and to speed efforts to deal with past problems. Countries that are growing quickly, like some emerging markets, must be alert to the danger of overheating, the group said.

“The signs of financial imbalances are there,” Mr. Borio said. That’s why we are emphasizing it is important to take further action while the time is still there.”

The B.I.S. report said debt levels in many emerging markets, as well as Switzerland, “are well above the threshold that indicates potential trouble.”

Yet investors show no sign of being deterred. This month, for example, investors snapped up $1.5 billion worth of bonds sold by the government of Kenya. The debt paid an interest rate of 6.875 percent, very low for a country that has deep economic problems and has been rocked by terrorist bombings.

In contrast to many economists and analysts, the B.I.S. played down the risk of deflation, a downward spiral in prices that can have devastating economic effects. When deflation takes hold, people stop spending because they expect prices to fall further. Company profits slump, and unemployment rises.

In Europe, an intense debate has taken place about whether the region could slip into deflation, and whether the European Central Bank should be pumping more money into the euro zone economy as a countermeasure.

Mr. Borio said it was unlikely that there would be a repeat of the kind of catastrophic deflation that occurred during the Great Depression. He noted that prices have been falling in Switzerland for several years, but the country has continued to grow, and unemployment is low.

“We are not saying deflation is not a problem,” Mr. Borio said. “But we would like to try to take a little bit of the emotion out of the debate.”

The organization also had harsh words for corporations, which it said were not taking advantage of booming stock markets to step up investment. That is one reason that gains in productivity — the foundation of sustained economic growth — have slowed in most advanced economies, the bank said.

Despite the euphoria in financial markets, investment remains weak,” the B.I.S. said. Instead of adding to productive capacity, large firms prefer to buy back shares or engage in mergers and acquisitions.”

The overall, somewhat gloomy message from the central bankers was that the world is drunk on easy money and has already forgotten the lessons of recent years.


“The temptation to postpone adjustment can prove irresistible, especially when times are good and financial booms sprinkle the fairy dust of illusory riches,” the report said. “The consequence is a growth model that relies too much on debt, both private and public, and which over time sows the seeds of its own demise.”