John P. Hussman, Ph.D.
Last week, the financial markets mounted a striking shift back to the "risk-on" trade, as investor concerns about a recession were abandoned, and Wall Street came to believe that Europe will easily contain its banking problems. Accordingly, downside protection was largely discarded (as reflected by a plunge in the CBOE volatility index), price-volume action reflected heavy short-covering short sales, investor interest shifted strongly away from defensive sectors to speculative ones. For defensive investors, it was admittedly a difficult week, as the markets suddenly became convinced that no defense was needed, and treated defensive investments accordingly.
From my perspective, Wall Street’s "relief" about the economy, and its willingness to set aside recession concerns, is a mistake born of confusion between leading indicators and lagging ones. Leading evidence is not only clear, but on a statistical basis is essentially certain that the U.S. economy, and indeed, the global economy, faces an oncoming recession. As Lakshman Achuthan notes on the basis of ECRI’s own (and historically reliable) set of indicators, "We’ve entered a vicious cycle, and it’s too late: a recession can’t be averted." Likewise, lagging evidence is largely clear that the economy was not yet in a recession as of, say, August or September. The error that investors are inviting here is to treat lagging indicators as if they are leading ones.
The simple fact is that the measures that we use to identify recession risk tend to operate with a lead of a few months. Those few months are often critical, in the sense that the markets can often suffer deep and abrupt losses before coincident and lagging evidence demonstrates actual economic weakness. As a result, there is sometimes a "denial" phase between the point where the leading evidence locks onto a recession track, and the point where the coincident evidence confirms it. We saw exactly that sort of pattern prior to the last recession. While the recession evidence was in by November 2007 (see Expecting A Recession ), the economy enjoyed two additional months of payroll job growth, and new claims for unemployment trended higher in a choppy and indecisive way until well into 2008. Even after Bear Stearns failed in March 2008, the market briefly staged a rally that put it within about 10% of its bull market high.
At present, the S&P 500 is again just 10% below the high it set before the recent market downturn began. In my view, the likelihood is very thin that the economy will avoid a recession, that Greece will avoid default, or that Europe will deal seamlessly with the financial strains of a banking system that is more than twice as leveraged as the U.S. banking system was before the 2008-2009 crisis.
It is certainly true that our aversion to these risks has been punished over the past couple of weeks, as investors have abandoned defensive positions in favor of speculative ones. But as always, our investment horizon remains the complete bull-bear market cycle, and there is no compelling evidence that the serious risks that we face have abated. On the valuation front, we presently estimate a 10-year prospective total return for the S&P 500 averaging just 4.8% annually (nominal), so long-term investment prospects are only weakly more encouraging than near-term ones.
While many Wall Street analysts continue to view stocks as cheap on the basis of forward operating earnings (which reflect expectations of a continued economic expansion and the maintenance of record profit margins indefinitely), the use of forward P/E multiples is a valid shorthand for discounted cash flow valuation only when profit margins reflect a level that is actually likely to be sustained over several decades. Even then, the benchmarks typically applied to forward operating earnings are actually based on historical norms for price-to-trailing net earnings.
Investors should recognize that P/E multiples are simply a crude shorthand for legitimate valuation calculations (specifically, the careful discounting of a whole stream of future deliverable streams of cash to the investor). P/E multiples subsume a whole set of assumptions regarding the entire future path of growth rates, profit margins, return on invested capital, and other factors. The common practice of valuing the stock market based on "forward operating earnings times arbitrary P/E multiple" is not only misguided – it’s an utterly disappointing display of Wall Street’s willingness to dumb-down the investment process. As investors have discovered through more than a decade of zero returns, the constant abandonment of intellectual effort comes at a cost over the long-term. This is a good opportunity for investors to review their tolerance for significant losses. My impression is that this may be the best opportunity to reduce risk that investors are likely to see for a while.