John Hussman: Extend and Pretend
John Hussman of www.hussmanfunds.com puts out a Weekly Market Comment (which I highly encourage you to read every week). Per usual, this is another good article.
Extend and Pretend
John P. Hussman, Ph.D.
April 12, 2010
Over the past 12 years or so, I've been repeatedly astonished at the tendency of investors to do things that they should have known to avoid simply with the use of a calculator and basic arithmetic. We've used numerous metrics during this period to show that the estimation of long-term market returns (7-10 years and beyond) doesn't require calculus or statistics, but fairly direct methods to normalize earnings, plus a bit of arithmetic. Rich valuations are predictably followed by sub-par returns. As a result, investors have earned an average annual total return of just 2.4% in the S&P 500 over the past 12 years, while enduring two separate instances where they have lost about half of their money as part of the ride. Essentially, we have gone nowhere in an interesting way. At present, investors have priced the market at a level that makes a continuation of this experience likely for several years to come.
I noted last week that at current valuations, the S&P 500 is priced to deliver a total return of only about 5.7% annually over the coming decade. Though it generally takes about 7-10 years to reliably revert from valuation extremes, a good portion of that reversion often occurs within 5 years (outside of the twin bubbles to the 2000 and 2007 highs). Presently, a normalization of valuations, not to extreme undervaluation but simply a reversion to post-war, non-bubble norms, would imply an average annual return for the S&P 500 of just 2.97% over the coming 5 year period.
This outcome is not dependent on whether or not we observe a second set of credit strains, but is instead baked into the cake as a predictable result of prevailing valuations. The risk of further credit strains simply adds an additional layer of concern here. Investors have chased risky securities over the past year to the point where the risk premium for default risk has eroded to the levels we saw at the peak of the credit bubble in 2007. My sense is that this is a mistake that will be painfully corrected. Investors now rely on a sustained economic recovery and the absence of any additional credit strains - and even then would be likely to achieve only tepid long-term returns from these levels.