Hussman: Sorry, Market Still Overvalued

From Investment Intelligencer

In his weekly market letter, John Hussman of the Hussman Funds notes that the current market environment feels a lot like that of the late 1990s and then invokes a sobering statistic to back this up.  Hussman’s conclusion is the same as that of Jeremy Grantham, Andrew Smithers, Robert Shiller, and others: the U.S. equity market is still overvalued by at least 30%. 

As with all analyses based on mean reversion, Hussman’s assumes that past is prologue.  As a result, if something is "different this time" (which it sometimes is), the concern may be unfounded.  The bad news is that, if something isn’t different this time, if past is prologue, the outlook is very grim indeed.  The "mean" in a mean-reversion analysis is in the middle: half of the observations are above and half are below.  A drop of 30% in the market, in other words, would not necessarily take us to the bottom.  It would just take us to the mean.

Hussman:

Ever watch those old Road Runner cartoons where the Wile E. Coyote goes over the edge of a cliff holding an anvil and just hovers there for a moment, while it sinks in that he’s in trouble? That’s about what this market feels like. In particular, the current environment in housing, financials, and the stock market feels a lot like what we observed in the dot-com bubble in the late 90’s. It was the clear (or should have been) that speculation had gone too far, and that the excessive bullishness of investors would probably end badly. But even after individual stocks began to collapse, many investors maintained hope until it was far too late..

…[S]tocks remain very richly valued. The bait taken by investors here is the belief that the market’s “price-to-forward operating earnings” ratio is reasonable. Unfortunately, this morsel of bait carries a very sharp hook. “Forward operating earnings” did not even exist prior to the 1980’s, and if one proxies it historically as Cliff Asness has done (based on how it relates to other fundamentals with longer records), you find that the historical norm of “price-to-forward operating earnings” is about 30% below current levels. Adjusting for the present elevation of profit margins, the normalized level is probably even lower.

Posted by Henry Blodget on March 20

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