Hussman - Fair Value on the S&P 500 Has Three Digits

Weekly Market Comment
by John P. Hussman, Ph.D.
April 27, 2015

Excerpts:
Where is “fair value” today? We have to be careful here because the concept of “fair” depends on your assumptions about what a reasonable investment return should be. If I show you a security that’s expected to pay out $100 ten years from today, and I tell you that the current price is $82, you can quickly calculate that the expected return on that security is 2% annually – and you don’t need to know anything about interest rates to do that arithmetic. Interest rates come in after you do that arithmetic. Interest rates then matter only because they give you something to compare with that 2%. Now, if you decide that a 2% annual return over the coming decade is just fine with you, in view of competing alternatives, then it’s fine to call that security “fairly valued.” But even if you decide that the security is fairly valued, you should still expect a 2% annual return over the coming decade. If you viewed a 10-year return of 8% as reasonable, you’d peg “fair value” at $46.32.

On the basis of valuation measures best correlated with actual subsequent market returns, we can say with a strong degree of confidence that the S&P 500 would presently have to drop to the 940 level in order for investors to expect a historically normal 10-year total return of 10% annually. That 940 figure for the S&P 500 would not represent some extreme, catastrophic outcome. It’s not a level that would even represent undervaluation from a historical perspective. It’s the level that we would associate with average, historically run-of-the-mill long-term equity returns. As we observed at the 2000 peak, “if you understand values and market history, you know we’re not joking.”

That said, if one believes that depressed interest rates warrant not only a low prospective return on stocks, but also virtually no risk premium whatsoever despite their significant full-cycle volatility, then you might be quite happy with the prospect of a 1.4% annual nominal total return on the S&P 500 over the coming decade, which is what we presently estimate from current levels, based on a variety of historically reliable methods (see Ockham’s Razor and the Market Cycle for the arithmetic behind these estimates). In that case, you might consider stocks to be "fairly valued" here. But you should still allow for a 940 level or below on the S&P 500 over the completion of this market cycle.

One might think that low interest rates would preclude the possibility of the market losing more than half of its value, but historically, one would be wrong. Outside of the inflation-disinflation cycle from the mid-1960’s to the mid-1990’s, the historical correlation between 10-year Treasury yields and 10-year prospective stock returns has been far weaker than investors seem to believe. Indeed, except for the 2000-2002 cycle, the final low that completes a market cycle has historically taken the market well below run-of-the-mill valuation norms, even in periods prior to the mid-1960’s when interest rates were similarly low and much more stable.  One might think that Fed easing would preclude that possibility, until you realize that the Fed was easing aggressively and continuously throughout the 2000-2002 and 2007-2009 collapses.