John Hussman wrote an interesting note this week called Taking Distortion at Face Value. Although Hussman is traditionally bearish, he makes some critical arguments that are hard for any investor to ignore.
The entire commentary is worth reading, but here are a few key paragraphs:
I continue to expect the U.S. economy to join a global recession that is already in progress in much of the developed world (assuming a U.S. recession has not already started, which we can’t rule out, but would require knowledge of eventual data revisions to confirm). Suffice it to say that the realistic case for a sustained economic expansion here remains terribly thin.
The upshot is very simple, the U.S. stock market presently reflects two unstable features. One is that extraordinary monetary policy – specifically quantitative easing – has created an ocean of zero-interest money that someone has to hold at each point in time, and that provokes a speculative reach for yield. The other is that extraordinary fiscal policy, coupled with household savings near record lows, have joined to elevate profit margins more than 70% above their historical norm, as the deficit of one sector has to emerge as the surplus of another. The result is that investors quite erroneously accept the distorted “earnings yield” of stocks (and the associated “forward price/earnings multiple” of the S&P 500) at face value, without any adjustment for elevated profit margins or the historical tendency for such elevations to be eliminated over the course of the business cycle.
Put simply, stocks are not cheap, but are instead strenuously overvalued. The speculative reach for yield, encouraged by the Federal Reserve, has created another bubble – which is not recognized as a bubble only because distorted profit margins create the illusion that stocks are reasonably valued. We presently estimate a prospective 10-year nominal total return for the S&P 500 of less than 3.5% annually. The likelihood of even this return being achieved smoothly, without severe intervening volatility and steep market losses, is roughly zero. This does not imply or ensure immediate market losses, but it doesn’t need to. On any horizon of less than about 6-7 years, we expect that any intervening returns achieved by the S&P 500 will be wiped out, and then some. Speculate if you believe that your exit strategy will dominate that of millions of other speculators, despite market conditions that are already overvalued, overbought, overbullish. In my view, all of this will end badly. (Hussman)
Checkout this chart.
The Hang Seng (broad Chinese equity market index) is graphed against the S&P 500 and the FTSE 100 (one hundred largest mkt cap on LSE), as a proxy for Chinese, American, European stock markets. Over the past two years, Chinese equities (blue) have dropped 10%, U.K. equities (green) barely broke even and just recently (since Jan 2013) gained 4.29%, and U.S. stocks (red) have gained 18.43% in value.
The NIKKEI 225 would have been included as a representation of Japanese equities, but returns have been somewhat driven by expected and recent Bank of Japan quantitative easing, gaining 54.47% in just the past 6 months. Prior to BoJ quantitative easing, Japanese equities exhibited similar performance to that of China and the U.K.
These markets have displayed a large divergence over the past two years. Definitely something to be aware of.