Fund manager John Hussman foresees seven lean years for stock investors who fail to get out of an extremely overvalued market while a tiny window remains open.
“The investors who successfully leave the equity market at current valuations will exit through a needle’s eye,” the Hussman Funds portfolio manager warns in his latest shareholder letter.
Hussman does not borrow the Bible’s “seven years of famine” quote, but the former finance professor does arrive at the same calculation when he writes that “our estimates of S&P 500 total returns are now negative at every horizon shorter than 8 years.”
Holding stocks for 10 years only generates expected returns of less than 1.8% per year, he says.
So, to investors who feel the Federal Reserve’s zero-interest rate policy offers them “no choice” but to hold stocks, Hussman’s letter seeks to remind them that their alternative is “to experience negative returns instead of zero.”
As is his wont, the quant manager goes through a little math whose purpose in this instance is to show that the Fed’s efforts to hold rates at zero comes at the expense of returns in future years.
Hussman calculates that current valuations are reasonable “only if one assumes more than two decades of zero interest rate policy” — and even then implying low equity returns in the “mid-single digits.”
The fund manager, who has warned about the overvaluation of stocks and the dangers of the Fed’s easy money policy for years now, laments that his analyses serve as “a lightning rod for disdain” that will only be appreciated “after the fact.”
But for those inclined to listen, he colorfully states that “what investors view as ‘wealth’ here is little but transitory quotes on a screen and blotches of ink on pieces of paper that have today’s date on them.”
In a market with weak trading volume, the opportunity to exit large positions is narrowing, he warns.
Not that investors are looking to exit a stock market that recently reached an all-time high (as the Dow Jones Industrial Average reached 17,000).
Pointing to a measure of volatility “indicating enormous complacency about potential risk,” Hussman also elucidates an esoteric concept called “unpleasant skew,” where the probability of short-term advances is greater than declines — an effect that “can feel excruciating for investors in a defense position."
The flip side, however, is the longer-term probability of “vertical drops that can wipe out weeks or months of market gains in a handful of trading days.”
While the bearish manager says broad measures imply a 10-year S&P 500 return of less than 1.8% annually, narrower measures that are more reliable are far less favorable — negative, actually.
The measure that Warren Buffett considers most accurate — the ratio of market capitalization to GDP — is now about 150% of its pre-bubble norm (even imputing growth in second-quarter GDP, which in reality fell 1%), Hussman says.
According to that Buffett-endorsed measure, the stock market is currently “beyond every point in history except for the final quarter of 1999 and the first two quarters of 2000,” Hussman warns.
Unusually, the fund manager ends his letter with extensive quotation, roughly equal in length to his own commentary, from the Bank for International Settlements.
The organization, known as the bank for central banks, warns its members (including the Federal Reserve) in notably stark terms about the dangers of suppressing interest rates for an extended period of time.
In a warning issued last week, BIS makes several disconcerting points. It states that investors are “dancing mainly to the tune of central bank decisions;” that volatility “has sagged to historical lows,” indicating that “market participants are pricing in hardly any risks;” and worries about a “disconnect between the markets’ buoyancy and underlying economic developments globally.”
That disconnect, essentially, is that “growth has disappointed even as financial markets have roared.”
The BIS warns central banks of the risk that their easy money policies “lose traction” by failing to stimulate aggregate demand even as longer-term problems accumulate.
In other words, the zero-rate policy “may simply succeed in bringing forward spending from the future rather than increasing its overall amount over the long run, while leading to a further rise in public and private debt.”
Such a policy can’t substitute for policies that “raise the production capacity of the economy by removing barriers to productive investment and the reallocation of resources,” it adds.
The BIS expresses the worry that central banks are now boxing themselves into a “debt trap” wherein holding rates at zero over a period of business cycles encourages high levels of public and private of debt that discourage central banks from raising rates for fear of damaging the economy.
That, BIS warns, would prevent the economy from reaching sustainable growth even as “monetary and fiscal policies run out of ammunition.”
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