I've been down for so long, it feels like up to me
The other day I caught some flack from a few people for talking about the price to earnings ratio of the S&P 500. Mock P/E all you want, and it certainly is not a perfect statistic, but many smart investors look at the P/E multiple of major indices to judge whether stocks in general are over or under valued. John Hussman is one such Intelligent Investor to borrow a phrase from Ben Graham.
In his weekly letter to investors, The Outlook is Not Up, But Very Widely Sideways, Hussman states that the price-to-normalized earnings multiple of the S&P 500 at the market lows during the worst markets in recent history, 1974 and 1982, was around 7. The S&P 500 would have to fall by 60% to match the most attractive bear market valuations that we have seen over the past four decades in what is arguably a worse recession than what we experienced during either of those periods.
If you don't like looking at price to earnings, how about price to book value? The S&P 500 is currently trading at approximately 1.9 times book value. At the market lows during 1974 and 1982 stocks fell to around 0.8 times book.
Hussman doesn't believe that the market is going to completely implode, just that the current rally has gotten ahead of itself and it is fairly expensive at its current level.
At the March lows, the S&P 500 was priced to deliver long-term returns in the 10-12% range. Certainly not bad, but only modestly above the norm on a historical basis, in an economy that faced (and still threatens to suffer) difficulties well outside the norm. While that might have been the final low, and we can't rule out further market gains, I still believe that it is a mistake to rule out eventual “revulsion.” I don't think that we need to match valuations that existed at the 1974 or 1982 lows, but at a multiple of 16 times our current estimate for normalized earnings, suffice it to say that the market is not cheap.
What we've seen in recent weeks has been a recovery of between 25-33% of the losses that the market has suffered since its 2007 peak, putting the S&P 500 up about 6% year-to-date in total return, with the Dow up about 2%. While that sort of recovery, in this event, has implied a significant gain given the extent of the prior losses, the rebound relative to the loss is not unusual (though not easily predictable either, since such rebounds can abruptly fail early or late into the bounce). I continue to believe that it is a mistake to treat the recent advance as if it has significant information content about the economy. We are observing only smaller negatives (and even those may only be a reprieve based on a temporary lull in the mortgage reset schedule).
Until now, “less bad than expected” has been enough for investors. As a friend of mine quoted last week from a song by The Doors, “I've been down for so long, it feels like up to me.” At this point, however, stocks are priced to require an economic recovery. That is a difficult bet, in my view, because as I noted last week, economic expansions are emphatically not driven by a “consumer recovery.” They are invariably driven by swings in gross domestic investment – capital spending, autos, housing, factories, and other outlays that are heavily reliant on debt financing. That's why housing starts have such a strong correlation with GDP growth.
It is a very hard sell to expect a sustained recovery in debt-financed gross investment in an economy under strong deleveraging pressure. That's particularly true since the U.S. itself has not financed a penny of the growth in U.S. gross domestic investment in more than a decade – all of the growth has been financed by foreign capital inflows via a massive current account deficit. With government spending now drawing on those foreign savings to defend bank bondholders from losses, and a continuing need to shrink the current account deficit in the years ahead, gross domestic investment is likely to continue to be squeezed. We are in the midst of – and will continue to require – perhaps the largest adjustment in U.S. personal, corporate and government balance sheets that we will see in our lifetimes. This will be a very long slog. The outlook is not up, but very widely sideways.