Hussman Weekly Market Comment: Margins, Multiples, and the Iron Law of Valuation

The equity market remains valued at nearly double its historical norms on reliable measures of valuation (though numerous unreliablealternatives can be sought if one seeks comfort rather than reliability). The same measures that indicated that the S&P 500 was priced in 2009 to achieve 10-14% annual total returns over the next decade presently indicate estimated 10-year nominal total returns of only about 2.7% annually. That’s up from about 2.3% annually last week, which is about the impact that a 4% market decline would be expected to have on 10-year expected returns. I should note that sentiment remains wildly bullish (55% bulls to 19% bears, record margin debt, heavy IPO issuance, record “covenant lite” debt issuance), and fear as measured by option volatilities is still quite contained, but “tail risk” as measured by option skew remains elevated. In all, the recent pullback is nowhere near the scale that should be considered material. What’s material is the extent of present market overvaluation, and the continuing breakdown in market internals we’re observing. Remember – most market tops are not a moment but a process. Plunges and spikes of several percent in either direction are typically forgettable and irrelevant in the context of the fluctuations that occur over the complete cycle. 

The Iron Law of Valuation is that every security is a claim on an expected stream of future cash flows, and given that expected stream of future cash flows, the current priceof the security moves opposite to the expected future return on that security. Particularly at market peaks, investors seem to believe that regardless of the extent of the preceding advance, future returns remain entirely unaffected. The repeated eagerness of investors to extrapolate returns and ignore the Iron Law of Valuation has been the source of the deepest losses in history. 

A corollary to the Iron Law of Valuation is that one can only reliably use a “price/X” multiple to value stocks if “X” is a sufficient statistic for the very long-term stream of cash flows that stocks are likely to deliver into the hands of investors for decades to come. Not just next year, not just 10 years from now, but as long as the security is likely to exist. Now, X doesn’t have to be equal to those long-term cash flows – only proportional to them over time (every constant-growth rate valuation model relies on that quality). If X is a sufficient statistic for the stream of future cash flows, then the price/X ratio becomes informative about future returns. A good way to test a valuation measure is to check whether variations in the price/X multiple are closely related to actual subsequent returns in the security over a horizon of 7-10 years.