Long-Term Returns

“On the basis of a broad range of valuation measures that are tightly (nearly 90%) correlated with actual subsequent S&P 500 total returns over the following decade, we estimate that stock prices are about double the level that would generate historically adequate long-term returns.T hese are, of course, the same methods that allowed us – in real time – to project negative 10-year total returns for the S&P 500 in 2000 even under optimistic assumptions, to identify severe overvaluation in 2007, and to quantify the shift to reasonable valuations in late-2008 and 2009 (our stress-testing response to the credit crisis was emphatically not based on valuation). Note also that valuations are not the sole driver of our investment stance, as should be clear from our shift to a favorable market outlook in early 2003, following the 50% market plunge in 2000-2002.

Valuations adjust, and market conditions change. I fully expect to observe outstanding investment opportunities over the completion of the present market cycle and the next, even if a moderate retreat in valuations leaves them well above historical norms (as we saw in 2003). Now is not the moment to feel rushed to commit capital to a Fed-induced speculative carnival.

Needless to say, Wall Street wishes investors to believe that valuations are just fine, and one can hardly watch CNBC for 10 minutes without some reference to stocks being “cheap on forward earnings.” There are clearly useful ways to use forward operating earnings to obtain useful estimates of prospective equity returns (as shown above). But investors should be aware of the profound inaccuracy of valuation estimates based on unadjusted price/forward operating earnings and the “Fed Model” (which largely underlie the “equity risk premium” claims of Greenspan, Bernanke, and Yellen). The fact is that the errors of those models can be predicted in advance from the level of profit margins at the time of the forecast. The higher the level of profit margins, the more these models tend to overestimate future returns, compared with how stocks actually perform in the following years. The glib confidence placed in these models in 2000 and 2007 is enjoying a full – and likely tragic – revival at present.” (John P. Hussman, Ph.D.)

Long Term Returns


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