John Hussman is highly respected for his prodigious use of data and adherence to what it tells him about the state of the financial markets. His regular weekly market commentary is widely regarded as one of the best-researched, best-articulated publications available to money managers.
John's public appearances are rare, so we're especially grateful he made time to speak with us yesterday about the precarious state in which he sees global markets. Based on historical norms and averages, he calculates that the ZIRP and QE policies of the Fed and other world central banks have led to an overvaluation in the stock market where prices are 2 times higher than they should be:
John Hussman: What's interesting here is that if you think about equities, they're not a claim on next year’s prediction of earnings by Wall Street analysts. A stock, in fact any security, is a claim on any long-term stream of cash flows that investors can expect to be delivered to them over a very long period of time.
When you look at equities you can calculate something called duration. It's essentially the effective life of a security over which you are collecting cash flows in return for the amount you pay. For the S&P 500 the duration is about 50 years. In other words it is a very, very long-term asset. The only reason you would want to price that asset based on your estimate of next year’s earnings is if you were convinced that next year’s earnings are actually representative of the very, very long-term stream — and I'm talking 50 years or so of earnings that you're likely to get — that those earnings are in a sense accurately proportional to the whole long-term stream.
What's amazing about that is that is it has never been true. It has never been true historically. If you look at corporate profits and especially corporate profit margins, they're one of the most cyclical and mean-reverting series in economics. Right now, we have corporate profits that are close to about 11% of GDP, but if you look at that series you will find that corporate profits as a share of GDP have always dropped back to about 5.5% or below in every single economic cycle including recent decades, including not only the financial crisis but 2002 and every other economic cycle we have been in.
Right now stocks as a multiple of last year’s expected earnings may look only modestly over valued or modestly richly valued. Really if you look at the measures of valuation that are most correlated to the returns that stocks deliver over time say over seven years or over the next 10 years the S&P 500 in our estimation is about double the level of valuation that would give investors a normal rate of return.
So right now, we've got stocks valued at a point where we estimate the 10 year prospective return on the S&P 500 will be about 1.6 to 1.7% annualized — talking right now with the S&P 500 at 2032 as of today’s close.
Chris Martenson: I guess 1.6 or 7% doesn’t sound bad if you are getting 0% on your risk-free money, I guess. But this says that any move by the Fed to normalize — which means rates have to go up — any move to drain liquidity from the system is going to have its own impact. If we held all things equal, a normalization effort is going to then basically expose that the stock market is roughly overvalued by 100%.
John Hussman: 100%, yes. I actually think the case is a little bit harsher than that; in fact, quite a bit harsher than that.
The idea that well, "1.7% isn’t so bad" or "1.6% isn’t so bad" ignores the fact that really in every market cycle and economic cycle we have had a point where stocks were fairly valued or undervalued.The only cycle in which we didn’t see that was actually the 2002 low where stocks actually ended that decline at an overvalued level on a historical basis. But valuations were still relatively high on a historical basis in 2002. They got slightly undervalued in 2009, but not deeply.
On a historical basis, what's interesting is that if you look at measures of valuation that correct for the level of profit margins, you actually get about a 90% correlation with subsequent 10 year returns. That relationship has held up even over the past several decades. It has held up even over the past 5 years where the expected return that you would have forecasted based on time-tested valuations turned out to be pretty close to what you would have forecasted 10 years earlier.
Right now, like I say, we are looking at stocks that have been pressed to long-term expected returns that are really dismal. But more important than that, in every market cycle that we've seen with the mild exception of 2002, we've seen stocks price revert back to normal rates of return. In order to get to that point from here, we would have to have equities drop by about half.
This is one of the highest-quality and deepest-diving podcasts we've recorded in the 3-year history of our series. Part 1 is publicly available below. Part 2 can be accessed here (enrollment required).
Click the play button below to listen to Part 1 of Chris' interview with John Hussman (26m:29s):
Chris Martenson: Welcome to this Peak Prosperity podcast. I am your host, of course, Christ Martenson. How do we make sense of the world’s financial markets? Professionals all across the spectrum of investments and investing are increasingly turning sour on the markets that the central banks have created, and sometimes are even revolted by what they see. Not everyone, but the chorus is growing. Something is wrong with the markets. What is wrong can be summed up in one word I think: speculation. As today’s guest is going to put it—he put it so well recently—the entire global financial system has been turned into a massive speculative carry trade. And if you think that fundamentals no longer matter and that central banks can control every wiggle and tune every economic dial to the heart’s content, then you probably shouldn’t listen to this podcast at all because it's going to be a waste of your time. But if you know that prosperity cannot be printed out of thin air and that reversion to the mean is an important concept, you are going to love this podcast.
Today we are going to talk with one of my favorite people in the world, a great guitar player and a true gentleman and a friend, John Hussman. The principal at Hussman Funds. John, hey it is a real treat to have you on the program today.
John Hussman: Hey. Likewise. I love talking to you.
Chris Martenson: Thanks. I can’t think of any better place to start to describe today’s massively distorted financial environment then with the Bank of Japan’s recent move which we are calling Kuroda's Halloween Massacre, mainly because it sounds spooky. What did you take from that event in terms of what it tells us about the mindset of the Bank of Japan and where we are in this narrative of Central Bank inspired reflation, I guess we will call it?
John Hussman: There are actually two pieces to that. One is that it really smacks of desperation in some sense because the Bank of Japan has been doing this for quite some time. The Federal Reserve has made equivalent efforts. Really the idea behind quantitative easing is that if you create enough idle bank reserves you will somehow trigger spending. The way quantitative easing basically works is the central bank buys bonds that have been issued and they are held by the public and it goes out and buys those bonds and creates bank reserves and currency instead. Bank reserves and currency are what we call the monetary base. And the basic idea is that you make people uncomfortable holding zero-interest money. So if you got cash in your pocket, it is not earning anything and you got bank reserves that essentially aren’t being paid anything. In the US it is about a quarter of a percent that the Fed pays on idle reserves. But it is essentially nothing. If people are holding these very low interest assets, they reach for yield. The whole mechanism behind quantitative easing, the whole economic argument for quantitative easing is that by holding interest rates low you will either stimulate intersensitive demand—housing and that sort of thing—but at this point we really don’t’ see that. The only other mechanism by which it could work is if people become so uncomfortable with zero interest rates that they feel forced to reach for yield in more speculative vehicles.
Now the Federal Reserve, Bernanke particularly, believed that if you made people speculate enough and they drove prices up enough that they would feel wealthier and go out and spend. That actually contradicts what economists have known for decades and what Milton Friedman won a Nobel Price largely for demonstrating which is that people don’t consume off of speculative sources of income. They don’t consume off of volatile asset prices. They consume off of what they believe their long-term permanent income is and their view of their long-term earnings power and so forth.
And so what we’ve seen in reality is very little effect from quantitative easing, but they keep on pushing this accelerator because it is all they know. It is kind of like if you give somebody a hammer everything looks like a nail. With these central banks, if you give them a tool like quantitative easing and they are allowed to do it and the public somehow maintains hope that it will have some effect, they have kept on doing it for some time. We are not seeing the effects. We are seeing enormous speculation though because when you got interest rates at zero, people sometimes feel forced to take risk. And if they feel forced to take risk, they will start doing it, and what we have seen is they have done it without reference to value. And right now we have some enormous valuation gaps in the market that will be closed over time.
Chris Martenson: Well, let’s talk about those enormous valuation gaps. Let’s start with equities. That is the headline show that people are watching and paying attention to. Now October starts. Equities have a tiny bit of a stumble. They are down 6, 7% depending on the index we are talking about. The Fed trots out Bullard who immediately says "hey, careful here people, we are going to keep interest rates low forever. We are going to throw more QE into this if we have to." I took that as a sign that even slight weakness can’t be tolerated in this market. Is that because do you think the Fed officials know they have created a speculative monster and they need it to keep going?
John Hussman: I actually think that Bullard was acting out of sync with the rest of the FOMC. I think there is less tolerance, except for perhaps Kocherlakota, to do more QE. I think the general view, at least at the Yellen Fed, is that there hasn’t been a great deal of benefit from that. And I do think that they are serious about moving the other way. I think it is going to be a much higher bar to getting more quantitative easing. Even in the event that we get normal cyclical weakness in the economy.
What I think happened with—certainly Bullard has been on the Dovish side of QE, but I think what is going on is that there is an increasing recognition that assets are at a speculative level. They wouldn’t admit that outright, except for Richard Fisher who has been very outspoken about it. I think broadly speaking, the view at the Fed is that they would like to get to a normalization of policy over time and that tweaking this with another round of QE isn’t likely to do a whole lot for the real economy.
Chris Martenson: Now what are your views on the impact of QE on the equity market stuff?
John Hussman: Alright, so what is interesting here is that if you think about equities they are not a claim on next year’s earnings. They are not a claim on next year’s prediction of earnings by Wall Street analysts. A stock, in fact any security, is a claim on a very long-term stream of cash flows that investors can expect to be delivered to them over a very long period of time. When you look at equities you can calculate something called duration. It is essentially the effective life of a security over which you are collecting cash flows in return for the amount you pay. For the S&P 500 the duration is about 50 years. In other words, it is a very, very long-term asset.
The only reason you would want to price that asset based on your estimate of next year’s earnings is if you were convinced that next year’s earnings are actually representative of the very, very long-term stream—and I am talking 50 years or so—of earnings that you are likely to get. In other words, that those earnings are in a sense accurately proportional to the whole long-term stream. What is amazing about that is that is it has never been true. It has never been true historically.
If you look at corporate profits, and especially corporate profit margins, they are one of the most cyclical and mean reverting series in economics. Right now we have corporate profits that are close to about 11% of GDP, but if you look at that series you will find that corporate profits as a share of GDP have always dropped back to about 5.5% or below in every single economic cycle, including recent decades, including not only the financial crisis but 2000, 2002, and every other economic cycle we have been in.
Right now, stocks as a multiple of last year’s expected earnings may look only modestly overvalued or modestly richly valued. But really if you look at the measures of valuation that are most correlated to the returns that stocks deliver over time—say over seven years or over the next 10 years—the S&P 500 in our estimation is about double the level of valuation that would give investors a normal rate of return.
So right now we have got stocks valued at a point where we estimate the 10 year prospective returns on the S&P 500 will be about 1.6 to 1.7% annualized. We are talking right now with the S&P 500 at 2032 as of today’s close.
Chris Martenson: I guess 1.6 or 1.7% doesn’t sound bad if you are getting 0 on your risk-free money I guess. But this says that any move by the Fed to normalize, which means rates have to go up, any move to drain liquidity from the system is going to have its own impact. If we held all things equal, a normalization effort is going to then basically expose that the stock market is roughly overvalued by 100%.
John Hussman: One hundred percent. Yeah. I actually think the case is a little bit harsher than that. In fact, quite a bit harsher than that. The idea that well, 1.7% isn’t so bad or 1.6% isn’t so bad ignores the fact that really in every market cycle and economic cycle we have had a point where stocks were fairly valued or undervalued. The only cycle that we didn’t see that was actually the 2002 low where stocks actually ended that decline at an overvalued level on a historical basis. We still ended up being able to reduce our hedges by about 70% after that bare market and get much more constructive. But valuations were still relatively high on a historical basis in 2002. They got slightly undervalued in 2009, but not deeply.
On a historical basis, what is interesting is that if you look at measures of valuation that correct for the level of profit margins, you actually get about a 90% correlation with subsequent 10 year returns. That relationship has held up even over the past several decades. It has held up even over the past five years where the expected return that you would have forecasted, based on time tested valuations, turned out to be pretty close to what you would have forecasted 10 years earlier.
Right now, like I say, we are looking at stocks that have been pressed to long-term expected returns that are really dismal. But more importantly than that, in every market cycle that we have seen, with like I say the mild exception of 2002, we have seen stocks price back to normal rates of return. At that point, in order to get to that point, we would have to have equities drop by about half.
Chris Martenson: Half. Well, some people are saying that because for instance, Bank of Japan—and I think the US Fed is in the same quandary—they can’t really allow rates to rise because then the interest expense for government debt would consume entirely whatever tax receipts they got after a certain point. For Japan that is a very low point. It is somewhere between 2 and 3% depending on which analysis you like. Looking at that, there is an argument to be made that the central banks can’t ever allow rates to go back to normal. The long-term historical norm in Japan was closer to 6%, now it is a blended rate of just under 2%, 1.5% somewhere around there. If it gets to 2 it is sort of like lights out from a mathematical debt cycle behavior sort of a standpoint. What do you say to that? Are the central banks really trapped and they can’t allow rates to rise, or do you think the markets have a mind of their own and rates will rise if they need to?
John Hussman: Essentially, I would like to suggest that the amount of risk that we see in the equity market does not predicate on whether the federal reserve or the bank of Japan raises rates at all. One of the things that is interesting is that if you look at the Federal Funds rate during the 2000 and 2002 decline and during the 2007, 2009 decline, both where stocks dropped half of their value. The NASDAQ during 2002 dropped more than ¾ of its value. In 2007/2009 the S&P dropped about 55% of its value. If you look at what interest rates were doing, what the Federal Reserve was doing during that period it was easing aggressively. It was cutting interest rates frantically during both of those declines. And so the idea that interest rates have to go up in order to trigger a down move really doesn’t get as much support in the historical data as people often suggest.
What actually happens, the most hostile condition that you can approach in the market is one where stocks have been in a very overvalued, overbought, over bullish condition for possibly several years. And then you start seeing a breakdown in market internals. And by market internals I mean breadth, I mean leadership, I mean advanced decline. Various indices failing to confirm highs and so forth. Because what is actually happening is when people are taking risk and they are very eager to take risk you will see them take risk in everything. You will see what we sometimes call trend uniformity. You will see not only stocks going up, high quality stocks, low quality stocks, junk bonds, advanced declines, small stocks, large stocks, utilities, transports, foreign stocks. In other words, when people are willing to take risk they are out there throwing the dice on everything and you can read that preference out of the uniformity or lack thereof of market action.
When you start seeing the following sequence of very overvalued, overbought, over bullish, extremely lopsided optimism about the market, extreme valuations, and then you start seeing a breakdown in market internals, (which is actually what we started to see several weeks back) and we still have not recovered in terms of internal action, then you are seeing a situation where there is an increased preference to avoid risk and where investors are becoming more risk averse; they are backing away. In that environment when you have very, very low, thin risk premiums and people are backing away from risk, it doesn’t matter that there is a lot of zero interest rate money out there because zero interest rate money in a risk averse environment is desirable.
What quantitative easing really relies on, and has relied on, is the view of safe, low interest rate money as kind of the pariah of the investment world. It is an undesirable asset, as an inferior asset. When risk aversion starts rising, that is no longer true.
So the Federal Reserve during 2000, 2002, during 2007, 2009 tried very hard to create a bunch of low interest, 0 interest rate money in order to try and turn things around. But during those environments low interest rate, safe money was not an inferior asset. So stocks lost half their value or more anyway. And I think that we are likely to get to that point.
I shouldn’t give timing, but I will say that we are seeing a lot more shortfall in the global economy than is widely observed here in the United States. And the likelihood of the United States decoupling from the global economy is not high. That is not to say I am expecting a recession right now. But what I would say is that if you start to see the purchasing managers index deteriorate toward 50 or below, if you start seeing the S&P below where it was six months earlier, if you see any quick uptick in the unemployment rate—even a few tenths of a percent—all of a sudden those small things which individually would mean nothing, if you see them in a syndrome, have generally been some of your first indications that the US economy is weakening. That, along with what we already see, which is a very narrow yield curve. You don’t have to have an inverted yield curve. You can't get one with zero interest rates on the short end. What you really need to trigger recession warning is just a yield curve that is not particularly steep. Right now we don’t have that. If we were to get those other components of that syndrome, you could say with a reasonable historical level of confidence that recession risks had grown considerably.
Chris Martenson: Now to get back to this idea of the market internals and the non-confirmations—I can’t turn on CNBC without them trotting out somebody who says "I love this market. Very bullish here. We have all the right signs." Obviously, a market has people taking both sides of a story. But the headline is that the Dow has hit all time new records and did it set another one today here on Friday? Probably. The non-confirms, what are you seeing out there in terms of other indexes and sub-indexes and components that aren’t confirming right now?
John Hussman: Small CAPs were really the first ones to roll over. But you are also seeing for instance if you look at the New York Stock Exchange Index, the composites, that has performed relatively weaker. It hasn’t confirmed the highs. You certainly see the advanced decline lines struggling. You see a tendency toward big pick ups in new lows. So even though we have been running at new highs and we are at all time highs, you see these big pick ups and new lows on relatively small amounts of weakness, which basically says that the average stock in the market is actually not participating as much. So there are a whole lot of these things.
The other one is really credit spreads – junk spreads, BAA versus AAA in the Moody’s. If you look at the uniformity of the market not only across stocks, but also across other assets, you are starting to get subtle indications of a shift in risk aversion. And those subtle indications unfortunately are sometimes all you get.
We saw that for instance in 1987 where in that particular instance you saw the subtle breakdowns occurring in utilities and junk bonds and so forth, corporate bonds—you really didn’t see anything else. It looked very strong up until the point where the bottom kind of fell out. You see generally, for instance, the 2000 top: We actually had breadth diverging for a long time and then you started seeing a concert of additional breakdowns which moved our measures to negative on September 1st of that year based on the same kind of analysis. And that was really the last hurrah that you saw on the index.
That is not to say that we haven’t been frustrated for an enormously long time in this cycle because one of the things that quantitative easing has done that I didn’t anticipate is that normally speaking, if you look at bull markets historically, once you have gotten to what we call an extreme syndrome of over-valued, over-bought, over bullish conditions (and these are measureable things that we use), once you got to that point, stocks kind of headed south in pretty quick order. And what quantitative easing has really done is it has sustained a very speculative meme a whole lot longer than has occurred in prior cycles. That has been very frustrating to us.
That is why we really have focused much more recently on this uniformity as well. That is one of the things that has always been good to us. It was good to us in 2000, was good to us in 2007 in terms of identifying the break points of those speculative episodes. And the fact that we are starting to see the same breakdowns here is really why we have been much more I guess aggressive in using warning words like... there are only three times where we have used the word "crash" in the headline of our weekly comments. One was in 2010, but it wasn’t a warning. It was more talking about the dynamic of bubble crash, bubble crash. And the other two have been in the past month because we are very concerned about the risk of abrupt things happening in this market because we are starting to see that internal deterioration, and that creates some sense that risk aversion is growing. That may reverse, and we kind of... our rule is to take our evidence as it comes. I may back down on the immediacy of my concerns. But here and now I would say those concerns are really quite high.
Chris Martenson: Let’s talk about this idea of being in bubbles again. The Fed famously hews to the idea that you can’t see them except in the rearview mirror, but it is obvious that we have a whole lot of speculative froth however you want to measure that, right? I have a variety of measures. One is I could look at price of stocks to their sales. And I got screen after screen of just absolutely monstrous price to sales ratios. Or I could look at price earnings. It used to be you would say put my filter at a PE of 200; you might get a page or two. Now I get several pages of PEs over 600. It is just astonishing. I have my own measures or looking at junk bonds that are yielding 5% in the five handle range. All of these things say to me that we are back at that sort of place. Would you agree with that definition that we are in the bubble psychology, the bubble pricing, that we are there again?