Hussman sees danger ahead

Top-performing mutual fund manager John Hussman sees no value in this “overvalued, overbought and overbullish” market.

Last week, the dividend yield on the S&P 500 dropped below 2%, versus a historical average closer to double that level. While part of the reason for the paucity of yield in the current market can be explained by the 20% plunge in dividend payouts over the past year, as financial companies have cut or halted dividends to conserve cash, the fact is that current payouts are not at all out of line with their historical relationship to revenues, and even a full recovery of the past year’s dividend cuts would still leave the yield at a paltry 2.5%. The October 1987 crash occurred from a yield of 2.65%, which was, at the time, the lowest yield observed in history, matched only by the 1972 peak prior to the brutal 1973-74 bear market.

Those two periods had a few other things in common. In the weeks immediately preceding the market downturn, stocks were overbought, had advanced significantly over prior weeks, bond yields were creeping higher, and investment advisory bearishness had dropped below 19%. All of those features should be familiar, because we observed them at the 1987 and 1972 peaks, and we observe them now…

So when will we accept more risk? Easy – when the expected return from accepting risk increases, or when the expected range of outcomes becomes narrower. Presently, two things would accomplish that. One is clarity, the other is better valuation.

First, and foremost, we have to get through the next 5-6 months, which is where we will at least begin to see the extent to which “second wave” credit risks materialize. We emphatically don’t need to work through all of the economy’s problems. What we do need, however, is for the latent problems to hatch, so we can have more clarity about what we’re dealing with. I’m specifically referring to the second round of delinquencies and foreclosures tied to Alt-A and Option-ARM loans, the requirement beginning in January that banks and other financials bring “off balance sheet” entities onto their books (which, as Freddie Mac observed in a recent footnote, “could have a significant negative impact on its net worth”), and the disposition of a mountain of mortgages that have been increasingly running delinquent, but where foreclosure has been temporarily delayed.


Hussman’s fund doesn’t go net-short, but past times when he’s gone fully-hedged have been good opportunities to think about short selling.

Do P/E’s matter?

Source: Irrational Exuberance, Robert Shiller, 2000

The average 12 month earnings for the S&P 500 from June 2000 to June 2009 (10 years) is $49.84.  The index earned $14.88 in 2008 and $7.62 in the 12 months through June 30, 2009. The respective PE’s at a value of 1000 are roughly 20, 65 and 130.

Assuming earnings soon rise to $50 and are sustained, a tall order in my opinion, the expected 20-year annualized return on the S&P would still only be about 1%. Is that enough to justify the risk that earnings do not recover? Shiller’s method of smoothing earnings over 10 years makes good sense, but what if that 10 years encompassed the greatest credit bubble in history, and it has now been popped? What is the expected return then? To look at it another way, I would say that your expected return on T-bills is very, very high in terms of stock.

The reality of S&P 500 earnings

To say that stocks are anything other than dangerously overpriced with a P/E of over 130 and a yield of 2.5% on unsustainable dividends is either farcical or fraudulent.


For such a simple little metric, the P/E ratio is subjected to all kinds of perversions to deflate it to levels that can be passed off as reflecting value. At the very least, most bubbleheads try to make it less scary than its current level of 133 for the S&P 500.

Do-it-yourself P/E and dividend analysis

It is very easy to find out what the real index PE is at any given time. Just google S&P 500 earnings, and right at the top you will see a link to an Excel file on S&P’s website. Download it and see the data for yourself. The file provides 20 years of history on operating earnings, “as reported” (net) earnings, and cash dividends for the benchmark big-cap index.  Here is a permalink to the latest Excel file.

When talking P/E ratios, look at “as reported earnings,” which are the real bottom line, or as close as today’s accounting methods get to it. “Operating earnings” are all the rage these days with the sell-side and CNBC crowd, since they of course are higher, as they don’t include pesky items like depreciation, taxes and interest. Even more ridiculous is the use of “forward operating earnings,” which are not an accounting entry at all, but just what Wall Street analysts are telling the public that companies might report in future quarters and fiscal years.

To get the real P/E, the one that has been used as a gauge of value for decades, take the sum of the last four quarters of “as reported earnings”. Through Q1 09, for which 99% of companies have now reported, the index has earned a 12-month total of $6.87 (with the index at 915, the P/E is 133).

An S&P analyst has noted in the file that if Q3 comes in as expected, trailing 12-month earnings will be negative for the first time in history (I bet CNBC will decide to ignore that little factoid, since it’ll be a hard one to spin). Earnings are down from an all-time 12-month peak of $84.95 as of Q2 2007. To be fair to the bulls, the current figures include a loss of $23 in Q4 2008, when financial companies took their write-downs, though surely more of the same are on the way, and not just for banks.

Today’s earnings vs. recent history

Q1 2009 earnings were about $7.53, and Q2 and Q3 are expected (analysts tend not to be that far off for quarters directly ahead) to be more or less the same, so we are on pace for about $30 in annualized earnings. A glace at the historical data shows that this is about the same level as in 2001-2003, after a peak of $48-54 for a few quarters in 1999 and 2000. You have to go back to 1994-1995 to again see the $30 level, with the $20 level about the norm from 1988-1993. Assuming that the $30 is sustained, you could say that the current P/E is 30. That’s not value in anyone’s book.

Dividends from la-la land

One particularly striking fact in this data is that 12-month dividends have hardly budged from record levels, coming in at $27.25 as of Q1 2009. Dividends had been growing fairly moderately and steadily from 1988 to 2005, increasing from the $9 to $20 level over 17 years. At the height of the credit binge, companies were flush with cash to give away and buy back stock at inflated prices, rather than pay down the debt they took on to generate those temporary earnings. That they are continuing to pay these high dividends says to me that managers are in total denial or are playing charades to maintain the illusion of health.

The index only yields about 2.5% on current dividends, but if dividends fall back to just 2004 levels, the yield would fall under 2% if the index still trades at 900. Keep in mind that secular bear markets bottom by enticing with high cash yields, as investors by then are too pessimistic to expect much in the way of capital gains. At the 1930s and 1970s bottoms, the market yielded over 10% and 7%, respectively. Just a 5% yield on 2005-level earnings ($20) would be the 400 level on the index. A 7% yield on 1998 yields would mean the index trades under 250.

Whether you are a deflationist or inflationist, you have to admit that a strong dose of either would not be kind to equity valuations. In the ’70s, people demanded high current yields because future yields were so heavily discounted by inflation, and in the ’30s, stock valuations became extremely depressed as earnings tanked and investors panicked.

A crude indication of solid stock values is when the S&P 500 yields over 5% and the P/E is under 10. Stocks can get cheaper than that, but at those levels you really can buy for the long run. To say that stocks are anything other than dangerously overpriced with a P/E of over 130 and a yield of 2.5% on unsustainable dividends is either farcical or fraudulent.


For reference, here is a link to S&P500 earnings and dividend data going back to 1960.

Glancing at the typical ratio of earnings to dividends, if the index is earning $30, one should expect dividends to be about $10-20. There is no record here of another time when dividends were higher than earnings, as they are at present. This says to me that the sustainable yield today is not even 2.5%, but more like 1% to 1.5%, comparable to the peak of the peak dot-com bubble.

From this level of overvaluation in the face of declining fundamentals, stocks could fall hard for another 18 months to restore value fast (1929-1932 model), in which case the 200 level is likely by 2011.  Another outcome is to trade in a range for a decade or more and wait and hope for a bout of moderate inflation to increase the nominal bottom line (1968-1982 model). A third possibility is the Japanese model, where the S&P would get to 200, but over 20+ years. Long-time readers know that as a deflationist and Elliott waver I expect the first outcome, with the most stunning phase of the bear market soon to come.

P/E’s are Nil on Dow and Russell 2000

Click image for sharper view. Source: Wall Street Journal Online

Earnings have gone negative. How’s that for value? Remember, most bear markets end with P/Es below 12, sometimes 7. Even the value play in the group, the S&P 500, will have to fall by more than half to get there, without any further contraction in earnings.

And what kind of fools see value in equity yields under 3%, when earnings have grown above trend for years? Stocks are all risk with no reward. You can get these yields on 1-5 year treasuries right now.