By many measures, S&P 500 valuations were high at the start of 2023. And yet, the index has performed impressively year-to-date, up 10.7% and climbing as high as 20%.
Near-term gains like this often cause investors to lose the bigger picture, says John Hussman, the president of the Hussman Investment Trust who called the 2000 and 2008 stock-market crashes. High valuations, despite their little influence on short-term returns, often mean devastating outcomes for investors over a longer period.
“Bubble extremes lead investors to forget history,” Hussman said in an October 13 commentary. “Investors look back on the advance of the preceding years, and see only that high valuations were followed by even higher valuations; that every setback was followed by a resumption of glorious returns.”
He continued: “They conclude that valuations are worthless. They imagine that the returns they enjoyed from the point of rich valuations to the point of extreme valuations are actually returns that they will keep over the complete cycle. Worse, like economist Irving Fisher catastrophically proposed in 1929, many investors insist that market cycles no longer exist, and that valuations will maintain a ‘permanently high plateau.'”
Hussman’s preferred valuation measure is the market cap of all non-financial stocks-to-gross value added from those stocks (essentially, total revenue). Right now, the ratio sits just below 2.95, a level that is historically associated with about -4% returns per year for the S&P 500 over the next 12 years.
Here’s a chart showing the close relationship between the ratio and subsequent S&P 500 returns.
But high valuations aren’t the only thing that concerns Hussman right now. There’s also what he calls “poor market internals,” which he tracks through a proprietary measure that monitors the breadth of individual stock performance. It’s one way to measure overall investor sentiment: if stocks are performing well across the board, investors are bullish. If good performance is sparser, investors are likely overall more skeptical.
Here’s Hussman’s measure of internals, shown in the red line. When it goes flat, internals are poor. Notice how in these periods, stocks tend to underperform. Also notice the two most extended flat periods before the current one were leading up to and during the 2000 and 2008 crashes.
The combination of poor internals and high valuations are why Hussman says losses could come out of nowhere, and quickly.
“Historically, the combination of extreme valuations and unfavorable market action has created a ‘trap door’ situation for the market,” Hussman said. “That doesn’t mean that the market always collapses in short order. Rather, the steepest market losses have generally emerged from that combination of market conditions, and these losses tend to emerge abruptly, without additional warning.”
Hussman is not kidding when he warns of steep and abrupt losses. He said the S&P 500 would have to drop 63% to return to valuation levels historically associated with 10% annual returns, or to levels that would deliver returns 2% higher than those on 10-year Treasury bills. When stocks have been this overvalued in the past, they’ve typically returned to more sustainable levels, shown in the chart below.
“Buckle up,” Hussman said.
Still, losses may not be that deep. A drop closer to 30% may be enough to turn Hussman bullish again, he said, but it would depend on market internals at the time.
Hussman’s track record — and his views in context
Since Hussman uses proprietary measures for both main elements of his argument — that valuations are too high and “market internals” are poor — let’s dig into other more common measures of the two, starting with valuations.
There are a vast number of valuation measures, but a popular one is the Shiller cyclically adjusted price-to-earnings ratio, which averages the PE ratios of the 10 preceding years. At 28.9, it’s lower than during 2021, the dot-com bubble, and the 1929 bubble. But it’s not far off 1929 levels, is above where it was leading up to the 2008 crash, and is higher than it’s been during almost all of the last 150 years.
Second is the equity risk premium, which values stocks based on where Treasury yields are. Since Treasurys are risk-free, investors should logically expect better returns in exchange for the higher risk they’re taking in stocks. Right now, the earnings yield from the S&P 500 over the next year is only expected to be a little less than 1% above Treasury returns. A 3-3.5% range is more historically normal.
Third, here’s the S&P 500’s 12-month forward price-to-earnings ratio, which values stock prices relative to how earnings are expected to perform over the coming year. It’s well off dot-com bubble and 2021 levels, but it’s still higher than levels commonly seen over the last couple of decades.
And fourth is the so-called Warren Buffett indicator, or total market-cap-to-GDP. It’s above dot-com bubble and 2008 levels.
So while different valuation measures can tell different stories, most measures say stocks are richly valued, albeit to varying degrees.
Now let’s switch to market breadth and investor sentiment. One way to measure market breadth is to look at the percentage of S&P 500 companies trading above their moving averages for various durations. As of last week, only 25% of S&P 500 companies were trading above their 50-day moving averages, a level associated with poor market performance.
As for investor sentiment, two popular indicators point to bearishness. One is Bank of America’s Bull & Bear Indicator, shown below alongside its components. Interestingly, it’s signaling that now is a good time to buy given how bearish investors are.
And then there’s CNN’s Fear and Greed Index, which shows investor sentiment is hovering on the line between “fear” and “extreme fear.”
For the uninitiated, Hussman has repeatedly made headlines by predicting a stock-market decline exceeding 60% and forecasting a full decade of negative equity returns. And as the stock market continued to grind mostly higher, he has persisted with his doomsday calls.
But before you dismiss Hussman as a wonky perma-bear, consider again his track record. Here are the arguments he’s laid out:
- He predicted in March 2000 that tech stocks would plunge 83%, then the tech-heavy Nasdaq 100 index lost an “improbably precise” 83% during a period from 2000 to 2002.
- He predicted in 2000 that the S&P 500 would likely see negative total returns over the following decade, which it did.
- He predicted in April 2007 that the S&P 500 could lose 40%, then it lost 55% in the subsequent collapse from 2007 to 2009.
However, Hussman’s recent returns have been less than stellar. His Strategic Growth Fund is down about 47% since December 2010, and has fallen about 6% in the last 12 months. The S&P 500, by comparison, is up about 16% over the past year.
The amount of bearish evidence being unearthed by Hussman continues to mount, and his calls over the last couple of years for a substantial sell-off began to prove accurate in 2022. Yes, there may still be returns to be realized in this new bull market, but at what point does the mounting risk of a larger crash become too unbearable?
That’s a question investors will have to answer themselves — and one that Hussman will keep exploring in the interim.