Lessons From a Lost Decade
by John P. Hussman, Ph.D., Hussman Funds
Over the past decade, stock market investors have experienced enormous volatility, including two separate market declines in excess of 50%. Despite periodic advances, at the end of it all, as a reward for their patience, investors have achieved an average annual total return of approximately zero. If the past decade has been a lesson for investors, that lesson should have two components. The first is that valuations matter. Though valuations often have little impact on short-term returns over periods of less than a few years, they are undoubtedly the single best predictor of long-term market returns. Moreover, high valuations are ultimately followed by far deeper periodic losses than emerge from low valuations. Put simply, greater risk does not imply greater reward if the risks that investors take are overvalued and inefficient ones.
The second lesson is that the effects of wasteful misallocation of capital cannot be fixed by policies that encourage the wasteful misallocation of capital. Fortunately or unfortunately, policies can often help to prop up unsustainable patterns of activity in order to "kick the can down the road." This can postpone major economic adjustments, but often makes the ultimate adjustment even worse.
Put simply, policies and investment practices that are effective and friendly to the short-term can often be destructive and violent to the long-term, particularly when those policies and practices encourage the misallocation of capital. Presently, investors are resting their financial security on hopes about quantitative easing - a policy that is essentially intended to skew the allocation of capital and provoke risk-taking in an environment where risk premiums are already thin.
Valuations
When starting valuations are elevated, investors require similarly elevated terminal valuations - 3 years, 5 years, 7 years, 10 years and further into the future - in order for stocks to achieve acceptable long-term returns. Investors and analysts entirely miss the point when they propose that stocks are "fairly valued" based on a short-term condition, whether it is the prevailing level of 10-year bond yields (which can change significantly over periods of much less than 10 years), the current inflation rate, or the expected level of next quarter's profits. Once valuations become elevated, particularly on profit margins that are also already elevated, investors require terminal valuations to be stretched to the limit, years and years into the future, in order for their speculation to be bailed out. At present, stock valuations are elevated on a variety of smooth metrics. In contrast, stocks appear reasonably valued only on metrics which place excessive weight on short-term factors, and which can therefore be shown to perform poorly in historical data.
Based on our standard methodology (see The Likely Range of Market Returns in the Coming Decade for the basic approach) we estimate that the S&P 500 is priced to achieve a 10-year total return of just 5.05% annually. Using our forward operating earnings methodology (see Valuing the S&P 500 Using Forward Operating Earnings), the projected 10-year total return is just 4.69% annually. With the S&P 500 dividend yield at 1.96%, the 10-year projection from dividend-based models is even lower, at about 2.30% annually (though prospects are good that faster growth of index-level dividends will bring that estimate closer to earnings-based projections, see No Margin of Safety, No Room for Error).
Overall, the projected returns for the S&P 500 are now lower than at any time in U.S. history prior to the bubble period since the late-1990's (which has resulted in predictably dismal returns for investors). At present, investors rely on a continuation of this bubble to achieve further returns. With respect to the bubble period, the current projected returns match those we observed at the April 2010 high, and are at about the same level as we observed before prices collapsed in 2008. Valuations were even more extreme, of course, at the bubble peak of 2000, which was predictably followed by a decade of zero returns.
