John Hussman - two observations

I really like John Hussman's work.

But, and there's often a but, I have two major criticisms.

1. John largely ignores the power of sustained changes in long term bond rates and the trend which has driven large parts of the increase in earnings multiples incorporated into prices, the Price Earnings (PE) ratio.

2. John looks at stock market valuation largely in isolation from the need to save/invest surplus funds and so largely ignores comparison with other investment opportunities (other than occasional references to bonds or cash).

1."Permanent" changes in the required/assumed earnings rate drives changes in capital value

We have been in a 30 year bull market in bonds as interest rates have slowly fallen from the highs of the war on inflation to the present day occasional fear of deflation. It is important to recognise that what John has called "yield seeking behavior" is not new, it is just played out in an adjusted context.

Some simple maths. The inverse of the rate of income is effectively the price multiple applied to the income stream. There are lots of potential qualifiers to that statement but lets accept it as a broad generalisation. If a an assumed permanent rate of earnings is 10 then the implied capital value is dependent on multiple applied. So if one assumes 10% pa in perpetuity the value is the inverse of 10% which is 10. If the assumed required yield is 8% then the multiple becomes 12.5x. If it is 5% the multiple is 20x, 3.33% it is 33, if it is 2.5% then 40, 2% then 50, 1.5% then 66.67x, 1.25% then 80, if 1% then 100, if 0.5% then 200 . Note that as the required earnings rate approaches 0 the multiple gets higher and higher (it approaches infinity). If the required rate is only 0.10% then the earnings multiple is 1000.

So looking at the last 30 years, the 3 year average of long term US bond rates have fallen from about 12% to about 2.5%, which implies a change in the multiple from 8.33 (100/12) to 40. A perpetual bond earning $12 at a yield of 12% was worth $100 ($12 x 8.33) but now the same bond would be worth $12 x 40 = $480. The fall in long term rates from 12 to 2.5 has resulted in a 480% increase in the capital value. This is permanent if the change in interest rates is permanent.

What happens if over the next 30 years the 3 year average of long term bond rates falls by the same proportional amount as over the last 30 years. Over the last 30 years they fell from 12 to 2.5 or by 79.17%, so they are only 20.83% of the 12 they once were . So if they fall from 2.5 by the same proportion over 30 years they will be only 20.83% of what they are now, that is in 2050 long term rates would be 0.52% and the perpetual bond earning $12 would be worth $2,307. Now lets see how much of an increase that is in the bond price. It was worth $100 in 1990, 480 in 2020 and in 2050 it is worth $2,307. So how much did it increase over the second 30 years? You guessed it, by 480% again!

As an aside, we have recently all learnt a couple of things.
a) there is no 0.0% lower bound of interest rates, central governments can manipulate them into negative territory times, even so negative that consumer rates can also be negative:
https://www.theguardian.com/money/2019/aug/13/danish-bank-launches-worlds-first-negative-interest-rate-mortgage
b) no matter how much a government is ideologically focused on reducing taxation and welfare and reducing budget deficits and repaying the debt, when it really hits the fan they will run huge deficits to maintain stability, or at lest to dampen the turmoil. (See US, British and Australian governments fiscal response to Covid19
c) central banks and governments can do "whatever it takes" (Mario Draghi European Central Bank) when they so decide, more so if they are a sovereign issuer of their own fiat currency, and moreso again if that currency is a global reserve currency. Such countries don't have to tax to spend, but that is another topic.

 So let's look at our long term institutional settings. Inflation targeting has been all the rage among central banks, but complicated by also having to target full employment, and all the while having to do this without any control over fiscal policy. If fiscal policy settings are too tight then interest rates will have to compensate by getting lower, even turning negative. If fiscal policy becomes overly expansionist then inflation might take hold and cause interest rates to rise. So the future depends significantly on the dance between fiscal and monetary policy of governments.

John has done analysis of US demographics (beforeCovid 19 hit) and made estimates of real growth in productivity and concluded that there is little to drive real growth in income per capita beyond about 2% pa. That means that in the absence of some black or white swan there is  little to cause huge economy wide demand for money for capital investment other than to achieve lower labor costs or to replace economically obsolete assets. Lower migration means lower population growth means lower housing demand and lower growth in GDP, all other things being equal.

So the big question is why do stock market averages that include when we were on the gold standard, when we were on a fixed exchange rate standard, while we were fighting a war on inflation, while we were fighting either World War matter at all? Why is the past any indicator of where things should be? Why should the market revert towards where it was at those times?

There are some economic policies that could make US GDP change at a different rate such as allowing an increase in immigration and rebooting manufacturing by moving away from free trade and towards isolationism, but these policies would be contentious and impose other costs, direct and indirect on parts of society that they would otherwise not suffer, but the policies would benefit the stock market and owners of capital.

2. The value of the stock market will ebb and flow around the outlook for other mainstream investments.

John looks at the value of the stock market not so much in relation to other asset such as real estate, gold, cash or commodities but in relation to what it used to be at some earlier time, whether a boom of a bust. He has recently been projecting very low to small negative returns in the US stock market over the coming 10 or 12 years. But what returns will real estate have, or cash, or bonds, or foreign currencies or commodities such as oil or soybeans? Will the stock market provide a higher return than those assets or lower? There are many advantages to investment in major stocks including no property taxes, no vacancy factors, low transaction costs, ability to sell small parts of a holding over time to provide funds for living in retirement and they also form part of any assessment on where to invest. On the other hand there can be more volatility and greater short terms losses and often people tend to sell after they have endured much of the fall and then not get back in before the market gets above where they sold.

John's analysis is also restricted to US stocks and that is understandable but it also ignores about 46% of the global stock markets. Will Japanese, German, UK or Chinese stock markets be better investments than the US market? Will the USD depreciate against the EUR?

So John's analysis is not about macro asset allocation either geographically or between asset classes and so is only relevant for that part of your investment funds that you have already decided to allocate to US stockmarkets. But it does not help much with decisions on stock picking, sector weightings, which indexes to follow through ETF's. So it is of little help in making specific investments other than a decision in relation to US ETF's which largely track the S&P 500.

There are however, people watching all these different markets and crossing over between them, so no one very large market is going to have a much higher expected risk adjusted rate of return than any other such market for very long as investors and fund managers will begin selling in one market and buying in the one with the higher expected risk adjusted rate of return, It could take weeks for any premium to dissipate, or it could happen almost instantaneously, but it will happen. So although the US S&P might have projected returns of only 0.5% over the long term, that might be more than the expected return from holding cash. All asset prices that are valued based on a return are susceptible to adjustment as long term bond rates move to new seemingly permanent lower of higher rates, for the reasons discussed at  1. above

Some techniques of investing accentuate new trends because as they emerge from the activities of some investors others identify a change in trend and jump aboard and there are various systems for choosing when to jump into a trend,

So while the expected return from the sock market is low, investors are betting that they will get a greater return there than from other alternatives such as cash or bonds, or the UK market or Japanese market.

Thanks John for all your great work, which I have been reading for over 10 years.