The Future is Now

John P. Hussman, Ph.D.

Even a return to median bull market valuations would be brutal for the most popular tech
stocks. Were not even talking about bear market valuations, and were making the leap of
faith, contrary to the evidence, that the quality of current revenues is as high as those
generated during the past decade. To illustrate the probable epilogue to the current bubble,
weve calculated price targets for some of the glamour techs, based on current revenues per
share, multiplied by the median price/revenue ratio over the bull market period 1991-1999.
Cisco Systems: $18 (52-week high: $82)
Sun Microsystems: $4 (52-week high: $64)
EMC: $10 (52-week high: $105)
Oracle: $6 7/8 (52-week high: $46)

Get used to those itty-bitty prices... And hey, were being optimistic.
[the above was written 13 years ago]

In the bear market that followed, those four horsemen of tech would fall about 50% below
the price targets noted above, except for Oracle, which halted its decline about 3/8 of a point
above that target.
Weve taken a great deal of care in recent months to emphasize that price/earnings ratios
are terribly unsuitable to gauge valuation (or estimate long-term prospective returns) unless
the earnings figure being used is representative and proportional to the very long-term, multi-
decade stream of future cash flows that will be made available to investors over time.
Unfortunately, profit margins vary dramatically over the course of the normal business cycle,
which demands that investors normalize earnings by accounting for the profit margins that
are embedded into them at any given time.
It turns out that every popular earnings-based measure (price to trailing earnings, price to
forward earnings, Shillers cyclically adjusted P/E, market capitalization to corporate profits)
can be made significantly more reliable by pairing the P/E multiple with a consideration of the
profit margin embedded within. Indeed, if we statistically relate P/E ratios and profit margins
(technically their logarithms) to actual subsequent 10-year market returns, we discover that
both factors enter the regression with nearly identical coefficients, meaning that the two can
be combined without any loss of information (see Margins, Multiples, and the Iron Law of Valuation).
Of course, the product of the P/E and profit margin (or the sum of their logarithms) is simply
the price/revenue ratio.
Lets be very clear earnings are absolutely essential to generate deliverable cash flows
for investors. Its just that profit margins vary too much to use year-to-year earnings (and to
some extent, even smoothed 10-year earnings) as a sufficient statistic for those multi-decade
cash flows. Revenues turn out to be much better sufficient statistics. When we look across
different companies and industries, of course, price/revenue multiples should and do differ
quite a bit. Low margin businesses (such as grocery chains) typically trade at very low
price/revenue multiples, while high margin businesses can justify higher price/revenue
multiples provided that revenues can be expected to be maintained or expanded for
decades, and the business has distinct competitive advantages that protect margins from
much erosion or variation over the economic cycle. There are fewer of those latter
companies in existence than people think theyre the ones that Warren Buffett tends to
gravitate toward.
The danger comes when investors drive price/revenue multiples to market-wide extremes,
across all stocks and industries. At bull market peaks, investors typically fail to recognize
cyclically elevated profit margins, assuming that those margins are permanent and that
earnings can be taken at face value. If there is one thing that separates our views here from
the bulk of Wall Street analysis, it is the historically-informed insistence that investors are
mistakenly banking on record-high profit margins to be permanent. For more on this,
including evidence that historical profit margin dynamics remain quite on track and have not
changed a whit, see The Coming Retreat in Corporate Earnings, and An Open Letter to the FOMC:
Recognizing the Valuation Bubble in Equities.
While the evidence may be alarming to some, make no mistake: The median price/revenue
multiple for S&P 500 constituents is now significantly higher than at the 2000 market
peak. The average price/revenue multiple across S&P 500 constituents is now above
every point in that bubble except the first and third quarters of 2000. Only the
capitalization-weighted price/revenue multiple presently at about 1.7 is materially below
the price/revenue multiple of 2.2 reached at the 2000 peak. Thats largely because S&P 500
market capitalization was dominated by high price/revenue technology stocks in 2000.
[Geek's Note: as a result, if one chooses a universe of stocks by first sorting by market
capitalization, one will probably find that price/revenue multiples of those stocks are lower
today than in 2000]. Regardless, the historical norm for the capitalization-weighted S&P 500
price/revenue ratio is only about 0.80, less than half of present levels. The fact is that unless
current record-high profit margins turn out to be permanent, against all historical experience
to the contrary, the overvaluation of the broad equity market is equal or more extreme today
than it was at the 2000 bubble peak.
Bill Hester and Jeff Huber here at Hussman Strategic Advisors compiled the chart below
using point-in-time constituents of the S&P 500 Index each quarter since 1990. Investors
often forget that smaller stocks struggled during the final years of the bubble as investors
clamored for glamour. Again, the broad stock market was much more reasonably valued in
2000 than it is today, as extreme valuations were skewed among the largest of the large
caps. Not anymore. The Federal Reserve has stomped on the gas pedal for years,
inadvertently taking price/earnings ratios at face value, while attending to equity risk
premium models that have a demonstrably poor relationship with subsequent returns. As a
result, the Fed has produced what is now the most generalized equity valuation bubble that
investors are likely to observe in their lifetimes.
As a reminder of where capitalization-weighted valuations stand, the following chart shows
the present ratio of market capitalization to GDP (shown on an inverted scale on the left, so
richer valuations are lower on the chart). Actual subsequent 10-year S&P 500 total returns
are plotted in red (right scale). Any belief that present levels represent a zone of
reasonableness is detached from the historical evidence. The entire market does not
deserve to be viewed as a wide-moat Buffett-type stock where earnings can be relied on as
a sufficient statistic of value.


All of this said, I would be remiss if I did not emphasize that valuation is not a timing tool. We
have a strong expectation that stocks will achieve weak total returns over the coming decade,
and negative total returns over horizons shorter than about 7 years. But as the investment
horizon shortens to less than a few years, other factors become more important in
determining market returns.
For our part, the condition and uniformity of market internals across a wide range of stocks,
industries, and security-types is an important consideration, as are extreme syndromes of
overvalued, overbought, overbullish conditions. Weve certainly observed overvalued,
overbought, overbullish features for much longer than is historically typical, though we do
believe that the consequences have been deferred rather than avoided. More importantly,
the market has lost significant momentum, the stance of monetary policy is shifting to a less
recklessly discretionary and more rules-based approach, and were observing increasing
divergences in market internals. A loss of uniformity in market internals has historically been
an important and subtle indication of rising risk aversion among investors.
The worst market outcomes, hands down, occur in those environments where rich valuations
are coupled with deterioration in market internals and a shift toward increasing risk aversion.
In contrast, the best market outcomes, hands down, occur in those environments where
reasonable or depressed valuations are coupled with early improvement in market internals
and a shift toward increasing risk tolerance. Though we fully anticipated the 2008 credit crisis
and had no qualms about valuation after the market plunged (see Why Warren Buffett is Right
and Why Nobody Cares), our greatest challenge in response to the policy errors that followed
was the necessity of stress-testing against Depression-era outcomes. That prevented us
from accepting opportunities in the recent half-cycle that both our pre-2009 methods and our
present methods had they been available at the time would have captured (particularly in
2009 and early 2010). But our subjective miss should not be a reason for investors to
ignore the objective risks over the completion of this cycle from what is now the richest
broad market valuation that investors are likely to observe in their lifetimes, and that is
increasingly coupled with divergent market action and deteriorating uniformity.
The likelihood is poor that from current price levels, broad equity investments even held for
nearly a decade will generate any positive investment return at all. Among the saddest
notes I received in the 2000-2002 and 2007-2009 bear markets were from people who had
short investment horizons (and were therefore forced sellers) and lamented I wish I had
listened. Whatever market returns we missed in the anticipation of those market declines
were easily lost by the market anyway once the bears gained control. Recall that the 2000-
2002 decline wiped out the entire total return of the S&P 500 in excess of Treasury bill
returns all the way back to May 1996. The 2007-2009 decline wiped out the entire total
return of the S&P 500 again in excess of Treasury bill returns all the way back to June
1995. I doubt that much of the markets gain since 2009 will be retained by investors over the
completion of this cycle. The run-of-the-mill bear market retraces more than half of the
preceding bull market gain. Those that begin from rich valuations wipe out far more.
Ive historically encouraged buy-and-hold investors to maintain their own investment
discipline, though with a realistic and historically-informed understanding of prospective
return and risk. At present, my concern is that many buy-and-hold investors are unaware of
how dismal prospective returns are likely to be from current prices, over every investment
horizon of a decade or less. Given the duration of the equity market (which mathematically
works out to be roughly the market price/dividend multiple), a passive 100% exposure to
equities is appropriate only for investors with a horizon of about 50 years. Passive buy-and-
hold investors would be well-advised to scale their equity exposures accordingly, based on
their own actual investment horizons. Meanwhile, it seems clear that investors have mentally
minimized their concept of potential downside, despite two 50% bear market losses in recent
memory that were both accompanied by aggressive Fed easing all the way down.
At present, the picture below is just a monthly chart of the S&P 500 since 1995. Not long
from now, perhaps less than 2 or 3 years, many investors will look at the same chart with
their head in their hands, asking What was I thinking? The central message to investors
with unhedged equity positions and investment horizons shorter than about 7 years:
Prospective returns have reached zero. The value you seek from selling in the future
is already on the table today. The future is now.