On a cyclical horizon, expect the present market cycle to be completed by a 40-55% decline in the S&P 500 Index; a historically run-of-the-mill from current valuations. John Hussman of the Hussman Funds

August 15, 2016

The Decade of Zero and its Chaotic Unwinding

John P. Hussman, Ph.D.

Imagine someone offers you a 10-year bond with a coupon yield (annual interest payment / face value) of 3.0%, and a current yield (annual interest payment / current price) of 2.3%. Let’s assume zero probability of default. Comparing this opportunity with the 1.5% yield-to-maturity available on 10-year Treasury bonds, would you prefer the bond “yielding” 2.3%? 

I’ve offered a hint by using quote marks, but if you chose the 2.3% bond anyway, you’ve joined the company of countless other investors who are making effectively the same mistake as they reach for yield across every financial asset. In order for a 10-year 3% coupon bond to provide a 2.3% current yield, one must pay $130 today in return for the following set of future cash flows: $3 a year for 10 years, plus $100 at the end. Paying $130 today in return for $130 in future cash flows, buyers of that bond will inadvertently discover that they’ve locked in a total return of zero. 

The error here is in using “yield” as shorthand for “expected total return on investment.” Focusing on yield alone quietly overlooks any consideration of capital loss - even when a capital loss is built into the deal. We increasingly see this error among stock market investors, as they incorrectly compare the dividend yield on stocks (annual dividend / current price) with prevailing interest rates, eliminating the “capital gain/loss” component of total return from their arithmetic.

DYI Comments:  Professor Hussman's is calculating yield to maturity in his bond example. This can be done in a similar fashion for stocks as their  - yield to maturity which is nothing more than market regressing up to or down to its mean.  The current dividend yield for the S&P 500 is 2.03% over the next 10 years the market could very well regress back to it mean yield of 4.39%! Estimated average annual return for stocks held today(or bought today) - go to sleep like Rip Van Winkle - wake up 10 years later your NOMINAL return will be in the neighborhood of 0% to 2%! My calculation below is based upon the ending yield of 4.0% marking this blogger as the optimist! Using 4.39% ending yield stocks most likely will end up where they started a 0% return! 

Estimated 10yr return on Stocks

Using 5.4% as the historical growth rate of dividends and 4.0% as the ending yield.

Starting Yield*---------return**
1.0%-----------------------(-5.7%)
1.5%-----------------------(-1.7%) 
2.0%------------------------1.3% You are Here!

2.5%------------------------3.8%

3.0%------------------------5.9%

3.5%------------------------7.8%

4.0%------------------------9.4%

4.5%-----------------------10.9%

5.0%-----------------------12.3%

5.5%-----------------------13.6%

6.0%-----------------------14.8%

6.5%-----------------------15.9%

7.0%-----------------------17.0%

7.5%-----------------------18.0%

8.0%-----------------------19.0%

*Starting dividend yield of the S&P500-**10yr estimated average annual rate of return.

Yet we know very well that valuations have reliably determined that component, in market cycles across a century of history. Indeed, the most historically reliable measures of market valuation (those with a correlation of 90% or more with actual subsequent 10-12 year market returns) currently project a likely S&P 500 nominal annual total return averaging just 0.9% over the coming 12-year period, with negative total returns at shorter horizons. 

As I detailed last week in Morton’s Fork, this outcome is likely to emerge almost regardless of the rate of economic growth and the level of interest rates over the coming decade. 

On a cyclical horizon, 

we continue to expect the present market cycle to be completed by a 40-55% decline in the S&P 500 Index; 

an outcome that would be historically run-of-the-mill from current valuations.

DYI Continues:  You nailed it Professor Hussman - the only disagreement DYI  is expecting a 45% to 60% decline.  A simple difference in crossing the t's or dotting the i's - too small to make any difference.

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DYI