September 24, 2012

We Have Already ‘Eaten the Future’: Hussman

Former finance professor says today’s market implies meager future returns while Fed manipulation ensures inflation

We've all heard that there’s no free lunch. But do investors understand that if they’re dining on champagne and caviar on a burger-and-fries budget today, they will be looking at peanut butter and jelly sandwiches, or bread and water, in the future?

That appears to be the lesson of Hussman Funds manager John Hussman’s latest shareholder newsletter called “Eating the Future,” commenting on today’s high securities prices.

John Hussman“Every security on earth works like this. The higher the price you pay for a given set of expected future cash flows, the lower your prospective future rate of return. Higher prices essentially take from future prospective returns and add to past returns. Conversely, lower prices take from past returns and add to future prospective returns,” Hussman (left) writes.

The former finance professor points out that investors buying 10-year Treasury debt today are procuring for themselves a meager 1.7% nominal annual return; 30-year bond investors are buying a 2.9% annual return; benchmark corporate bond investors are buying a 2.8% annual return; and S&P 500 stock investors are purchasing, based on Hussman Funds estimates of long-term cash flow projections, a nominal return of 4.1%. “The elevated prices of financial assets have already eaten the future,” he says.

Hussman makes a crucial distinction between changes in asset prices and wealth. Rising 10-year bond prices, for example, don’t increase wealth. “Regardless of today’s price, someone will have to hold that security until it delivers $100 a decade from now—no more, no less,” he writes. “Economic wealth is only created by the generation of additional goods and services…that actually emerge in the future.”

Hussman offers a stock-market illustration of this point as well:

“If a dentist in Poughkeepsie buys a single share of Apple a dime higher than the last guy did, nearly $100 million of market capitalization is suddenly created. Nobody suddenly pumped $100 million into the stock market. One person just paid up a little. All of that is the reason we insist on valuing securities based on the long-term stream of cash flows that we actually expect to be delivered into the hands of investors over time, not based on ephemeral measures like Wall Street’s estimates of next year’s earnings.”

So while a greater fool may be willing to buy your security for a higher price, “this does not mean that real output will be more plentiful in the future.”

To the contrary, Hussman argues that on an aggregate basis, today’s overconsumption of securities is eating into our future, as evidenced by the low cash flows expected from today’s securities prices. He asks:

“Are bond market investors actually ‘wealthier’ as a result of all of the [central bank] manipulation of asset prices? No. To the contrary, they are poorer. In aggregate, the real wealth of fixed-income investors has been assaulted” by expected inflation or higher long-term interest rates in the later years of this decade.

Hussman adds that inflation, the dread of bondholders, has historically been unkind to stock owners as well because it leads to increased wage and interest costs, and will likely shrink profit margins significantly below present levels, which he says are 70% above historical norms.

The lugubrious portfolio manager, who believes the U.S. economy is currently in an as-yet unrecognized recession, offers hope to individual investors who can still sell to the greater fools in the market, but gloom for the masses.

“Unfortunately,” he concludes, “the tragedy of the commons is that behavior that can be followed by a single individual is not always behavior that can be followed by all individuals taken together.”

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Read It’s the ‘Warped’ Financial System, Stupid: Hussman on AdvisorOne.

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