May 9, 2017
John Hussman, the fund manager who foresees a decade of meager stock-market gains, said the S&P 500 can fall as much as 40 percent to reach historical norms.
“Valuations are now so obscenely elevated that even an outcome that fluctuates modestly about some new, higher average would easily take the S&P 500 35 percent-40 percent lower over the completion of the current market cycle,” he said in a May 8 commentary.
The S&P 500 has risen about 12 percent to record highs since Republican Donald Trump won the November 8 presidential election on a platform of cutting taxes and regulation. That gain has pushed the Shiller price-to-earnings ratio, a measurement of how expensive stocks are in relation to company profitability, to about 29.5 times, compared with the historical average of 16 times.
Hussman focuses on the question of whether stocks have reached some kind of “permanently high plateau,” to paraphrase the notorious prediction by economist Irving Fisher nine days before the 1929 stock market crash that ushered in the Great Depression. This time around, the argument for elevated valuations rests on the idea that low interest rates and stagnant wage growth create a permanently better environment for corporate profit margins.
“The relationship between real interest rates and corporate profit margins is extremely tenuous in market cycles across history,” Hussman said. “The fact is that debt of U.S. corporations as a ratio to revenues is more than double its historical median, leaving total interest costs, relative to corporate revenues, no lower than the post-war norm.”
Labor costs adjusted for inflation have declined in recent years, a trend that may reverse and squeeze profit margins back toward historical averages.
“Though there will certainly be cyclical fluctuations, this process is likely to continue in an environment where the unemployment rate is now down to 4.4 percent and demographic constraints are likely to result in labor force growth averaging just 0.3 percent annually between now and 2024,” Hussman said. “Total employment will grow at the same rate only if the unemployment rate remains at current levels.”
The jobless rate last month fell to a 10-year low of 4.4 percent as U.S. companies added 211,000 workers. Labor market trends create a “dilemma for profit margins,” Hussman said.
“If economic growth strengthens in a tightening labor market, labor costs are likely to comprise an increasing share of output value, suppressing profit margins,” he said. “If economic growth weakens, productivity is likely to slow, raising unit labor costs.”
The “China price” for goods and the “India price” for services may not suppress U.S. wages much more.
“It’s tempting to imagine that offshoring labor would allow a sustained below-trend retreat in real unit labor costs,” Hussman said. “But while foreign labor can be cheaper, the corresponding productivity is also often lower, so the impact on unit labor costs is more nuanced than one might think.”
As corporate profit margins revert back to historical averages, stocks are more vulnerable to declines, he said.
“It has taken the third financial bubble in 17 years to bring the total return of the S&P 500 to 4.7 percent annually since the 2000 peak,” he said. “Don’t imagine that future returns will be much better from current valuations, even if future valuations maintain current levels forever. Indeed, my actual expectation is that the completion of the current market cycle will wipe out the entire total return of the S&P 500 since 2000.”
Hussman is president of the Hussman Investment Trust in Ellicott City, Maryland.