Introduction
This week's letter is from John P. Hussman, Ph.D., President of Hussman Investment Trust. His firm is one of the few that has employed hedging techniques, similar to the hedge fund world, in a mutual fund structure. John is also one of the really, really, really smart guys in the running money business. John manages the Hussman Strategic Total Return Fund - HSTRX and the Hussman Strategic Growth Fund - HSGFX.
Hussman's Weekly Market Commentary on August 22, 2005 takes a look at the relationship between stock market valuations, interest rates and inflation. He takes a look at what has happened to this relationship in the past and fills in the "omitted variables" other market cheerleaders seem to leave out.
This is a very short piece, but it is an important analysis of market valuations and why some people (including the Fed) might not be seeing statistical relationships the right way.
- John Mauldin
Omitted Variables
One of the nearly indelible assumptions about the current stock market is that
valuations "deserve" to be high because interest rates and inflation are
reasonably low. It accords with common sense that since stocks compete with
bonds, lower interest rates should generally be accompanied by higher
price/earnings multiples (and accordingly, lower future returns on stocks).
There's certainly some validity to this argument. We can observe, for instance,
that as interest rates have declined since 1980, earnings yields (the inverse of
P/E ratios) have also declined. This is conveniently summarized in the "Fed
Model", which assumes that the prospective earnings yield on the S&P 500 (on the
basis of expected operating earnings) should be equal to the 10-year Treasury
yield.
Unfortunately, the Fed Model dramatically overstates the relationship that
exists between interest rates and justified stock valuations. Stock valuations
began in the early 1980's at what were, objectively, very undervalued levels.
Indeed, the price/peak earnings ratio for the S&P 500 Index fell below 7 in
August 1982. Over the following two decades, stock valuations moved up to
extremely high valuations, peaking at over 30 times earnings during the recent
market bubble.
In other words, as interest rates declined, so did earnings yields. But a major
portion of that decline in earnings yields represented a long movement from
extreme undervaluation to extreme overvaluation, not a "fair value" relationship
with interest rates.
What's really going on here is something called "omitted variables bias." The
Fed Model explains the decline in stock yields since 1980 with one variable ?
the 10-year Treasury bond yield. But in fact, there are two variables at work.
One is the declining level of interest rates, sure. But the other is the move
from deep undervaluation to extreme overvaluation ? in other words, a profound
decline in the "risk premium" that stocks have been priced to deliver, over and
above what bonds could be expected to return. In 1982, the risk premium on
stocks was huge. At present, it's close to zero, and possibly negative.
So what the Fed Model picks up as "the effect of interest rates on stock
valuations" is actually the combined effect of interest rates and risk premiums.
As it turns out, interest rates and risk premiums on stocks have moved in a huge
cycle together since about 1965. Back then, interest rates were reasonably low,
and stock valuations were high. As interest rates rose into the early 1980's
stock valuations plunged. Then as interest rates declined back toward normal
levels, stock valuations advanced. So to a casual observer, it would seem very
obvious that stock valuations and interest rates go strongly hand-in-hand.
But here is the key: the relationship we've observed since 1965 between stock
valuations and interest rates has not been a "fair value" relationship. To the
contrary, stock valuations during this period have substantially "overshot" fair
value in both directions, becoming substantially overvalued when interest rates
were low, and becoming substantially undervalued when interest rates were high.
Interest rates may have been correlated with stock valuations, but they haven't
"justified" them.
To see this, the following table presents various ranges for the 10-year
Treasury bond yield since 1965, along with the actual total return that the S&P
500 achieved over the following 10-year period.
| 10-year Treasury Bond Yield |
Subsequent 10-year total return for S&P 500 |
| 0-5% |
4.34% |
| 5-6% |
5.46% |
| 6-7% |
10.54% |
| 7-8% |
13.18% |
| 8-9% |
16.68% |
| 9-10% |
17.49% |
Notice that when interest rates have been low during this period, subsequent
stock returns have also been low, and when interest rates have been high,
subsequent stock returns have also been high. Though this accords with our basic
intuition, the range of stock returns is far, far too wide. It doesn't make
sense that stocks should have returned 5.46% on average, when interest rates
were between 5-6%, but 13.18% on average, when interest rates were just two
percent higher. There's nothing that implies "fair valuation" in these figures.
Equally important, there's nothing "standard" in the relationship between
interest rates and stock valuations that we've seen since 1965. In historical
data before that point, interest rates and subsequent stock returns were
negatively correlated.
If we don't entertain the possibility that stocks have been both undervalued and
overvalued at various points over the past few decades, we end up attributing
far, far too much importance to interest rate movements as drivers of "fair
value." Worse, we risk overlooking the current, historically rich overvaluation
of stocks because we imagine that these valuations are "justified" by low
interest rates. Very simply, they are not. Stocks remain unusually overvalued,
and are likely to deliver disappointing long-term returns to buy-and-hold
investors purchasing at these prices.
Conclusion
I hope you enjoyed this week's Outside the Box. You can find more commentary by
Dr. Hussman at http://www.hussman.net/weeklyMarketComment.html.
Your waiting for cheaper valuations analyst,
John Mauldin
JohnMauldin@InvestorsInsight.com
www.2000wave.com
August 22, 2005
Copyright 2005 John Mauldin. All Rights Reserved.
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John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Thoughts from the Frontline may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273.
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