Markets don’t correct or experience significant drawdowns because of valuation, argues Landon Whaley.
The S&P 500’s massive decade-long rally has provided no shortage of gurus, bloggers, or media types calling for anything from a pullback to an outright crash in U.S. equities. The rationales that get attached to these claims never cease to amaze.
One of the culprits routinely named as a catalyst for the next market crash is valuation. If there is one thing people love to chirp about, it’s valuation, and there has been no shortage of bandwidth used to tout how overvalued U.S. stocks are right now.
To be clear, we aren’t one of the many perma-bullish or perma-bearish research firms; we are agnostic. We allow the data and our Gravitational Framework to tell us which bias to carry for a market, and when to be completely out of a given market.
The problem with the valuation argument is that equity markets don’t correct or experience significant drawdowns because of valuation. People don’t wake up one morning and suddenly decide that 20x earnings is too much to pay for the S&P 500.
Here, we pause to make a request of Warren Buffett disciples who make the pilgrimage to Omaha every year to kiss the ring and spend their weekends sifting through company balance sheets looking for the diamond in the rough.
We are not implying that valuation, as a metric, isn’t useful as part of certain investment strategies. What we are saying, however, is that using valuation to decide when the stock market is ready for a correction is like using the Super Bowl to determine the stock market’s future direction.
Back in the 1970s, Leonard Koppett figured out that the Super Bowl winner could accurately predict the future direction of the S&P 500. If the AFC won, the S&P would lose ground over the next 12 months. If the NFC won (an original, pre-NFL/AFL merger, NFL team), the S&P would gain in the following year.
At the time Koppett discovered this supposed “connection,” the Super Bowl had accurately predicted the S&P direction 100% of the time. As of last year, this predictor of S&P returns has been right 40 out of 50 years—an 80% success rate!
Clearly, the Super Bowl has no real connection to the S&P 500, and this is just a coincidence. Similarly, stock market valuation has no real connection to causing corrections—it can simply act as a downside accelerant once the correction begins for Fundamental Gravity reasons.
Paging Mr. Hussman
Enter John Hussman, aka “Captain Valuation,” who holds a Ph.D. and runs three mutual funds with over $350 million in assets under management. Hussman writes regular commentaries, all of which have valuation as their core theme. For years, he has been writing about how overvalued the U.S. equity market is. The problem for Hussman is that the market is continually becoming more overvalued.
In his latest commentary, Hussman is back to the soapbox about valuation: “Notably; current market valuations exceed both the 1929 and 2000 extremes. Not surprisingly, we estimate negative returns for the S&P 500 Index over the coming 10-12-year period, as valuations suggested in 1929, and as we projected in real-time in 2000. Meanwhile, given the depressed yields on long-term bonds, our estimate for 12-year total returns on a conventional asset mix (60% stocks, 30% Treasury bonds, 10% T-bills) has collapsed to just 0.8% annually.”
Whether he knows it or not, Hussman is taking one aspect of a market and using it to fear monger. He goes on to say, “It’s worth remembering that except for the 2000-2002 bear market, which ended at valuations that were still about 25% above historical norms, every other bear market decline in history, including the 2007-2009 decline, has taken reliable valuation measures to historical norms that presently stand between -60% and -65% below present market levels.”
You may be saying to yourself, “but he has a Ph.D. and manages over $300 million, he must know what he’s talking about!” Well, keep reading.
The Proof is in the Pudding
Folks, Hussman’s flagship fund, “Hussman Strategic Growth,” has lost money over the last one-month, three-month, one, three, five, 10, and 15 years. We couldn’t make this up if we tried! This guy’s fund is dead last in his Morningstar category over every one of those yearly time frames except the last year. Over those 12 months, he managed to make his way from the 100th percentile up to the 86th percentile when compared with other managers in his niche. Nice job, John!
I have absolutely no idea how this guy is even still in business, but the numbers don’t lie valuation is not the foundation for consistently successful investing.
This calamity story is another reminder of why it’s critical to be data-dependent and process-driven in financial markets. Don’t fall into the trap of being scared into believing the world is ending tomorrow just because markets are overvalued by a bunch of metrics that no one discusses until they reach historically extreme levels.
The Bottom Line
There will be many road signs for the next recession (or even crisis) before the real wealth destruction occurs. Those road signs will also be far more meaningful than all valuation metrics combined.
We see a difficult road ahead as we will explain in tomorrow’s post. However, it is best to follow our principles of focusing on now and watching the slopes and extremes of economic and financial market data, and you’ll be well-prepared and able to pivot your portfolio when the time comes.
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