John Hussman over at Hussman Funds writes a weekly letter published on Mondays that is always carefully researched and thought-provoking. Those of you who know him know he’s none to impressed with current market prices relative to value. John has done a wonderful job to maintain a learning mindset about the market. He know’s what he doesn’t know and has been relentless about improving his methods continuously to better his macro understanding.
John’s points in this week’s letter regarding “bubble formation” and the structural issues that lead to bubbles are spot on. Bubbles are always the result of some structural imbalance or another and always get blown out of proportion thanks to leverage — borrowed money. Everyone jumps in because the funding is cheap and whether its housing or Tech shares or Chinese infrastructure or the carry trade or seeking yield in any corner possible or impulsive M&A – real, growth-driving investments suffer because corporations KNOW the “growth” is not REAL. It’s temporary. So they take a wait and see attitude because no one wants to be left holding the bag…again. Even the cyclical sectors like oil and gas are getting the message and have managed this years oil price rout far better than in the past – despite it’s challenges.
Understanding the relative value of the market is a task that has vexed many people for a very long time. Effectively, this process seeks a “crystal ball” by which one could look at aggregate market valuations and “see” where the market will be headed next. This kind of macro forecasting keeps many an economist game-fully employed. Understanding valuation is important, and in Erik’s What do Stock Prices Reflect? blog post, we see another approach at getting a handle on where we are. What you quickly realize is that these two methods – Hussman’s look at Market Cap / Gross Value Added and the Brock Value look at GDP based sources – generate vastly different investment conclusions despite both appearing perfectly rational AND having some clear correlation with the actual equity market performance.
Interestingly, both approaches use a “return to the mean” argument, though both are looking at different means. Hussman’s approach looks at a ratio of (something like) Price-to-GDP* and assumes that relationship will be stable over time. Brock’s method assumes that the Price-to-GDP relationship to Aaa bonds is stable over time.
In general, ratio analyses are prone to errors (for reasons that we explore in IOI 102), so I am suspicious about both approaches, but in this case, Hussman’s conclusions seem more suspect. On the basis of his analysis, the market’s value is roughly 47.5% less than it’s trading for today (taking the midpoint of his stated cases). I would be the last to say that index prices couldn’t fall to a 1,083 level, but I would be much more suspicious about its value being that, simply resorting to a back-of-the-envelope calculation. The average GDP during the three periods of history (1998, 2003, and 2008) when the S&P traded around the 1,083 level is $11.4 trillion. In the most recent print, US GDP was $18.1 trillion. GDP has grown by 59% — shouldn’t equity values have increased over this time as well? Think about the autumn of 2008 (Lehman crash) and the spring of 2003 (post-911 build up to Iraq War) — did equity prices seem “about fair” then? What I remember is firms trading for the replacement value of their assets and below!
This Hussman letter is interesting (but long), so it is worth a read, if even just for the discussion of the factors leading to bubbles. However, as you read, remember the admonition repeated in IOI 102 — financial ratios are not constants of nature.
* Hussman actually uses a ratio of price to something called “Gross Value Added.” GVA is a measure of the total revenues of our economy.
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