Margins, Multiples, and the Iron Law of Valuation 
John P. Hussman, Ph.D.

The equity market remains valued at nearly double its historical norms on reliable measures of valuation (though numerous unreliable alternatives can be sought if one seeks comfort rather than reliability). The same measures that indicated that the S&P 500 was priced in 2009 to achieve 10-14% annual total returns over the next decade presently indicate estimated 10-year nominal total returns of only about 2.7% annually. That’s up from about 2.3% annually last week, which is about the impact that a 4% market decline would be expected to have on 10-year expected returns. I should note that sentiment remains wildly bullish (55% bulls to 19% bears, record margin debt, heavy IPO issuance, record “covenant lite” debt issuance), and fear as measured by option volatilities is still quite contained, but “tail risk” as measured by option skew remains elevated. In all, the recent pullback is nowhere near the scale that should be considered material. What’s material is the extent of present market overvaluation, and the continuing breakdown in market internals we’re observing. Remember – most market tops are not a moment but a process. Plunges and spikes of several percent in either direction are typically forgettable and irrelevant in the context of the fluctuations that occur over the complete cycle. 

The Iron Law of Valuation is that every security is a claim on an expected stream of future cash flows, and given that expected stream of future cash flows, the current price of the security moves opposite to the expected future return on that security. Particularly at market peaks, investors seem to believe that regardless of the extent of the preceding advance, future returns remain entirely unaffected. The repeated eagerness of investors to extrapolate returns and ignore the Iron Law of Valuation has been the source of the deepest losses in history.

DYI Comments:  Once again John Hussman provides top notch insights into the gross overvaluation of the U.S. stock market.  The entire article is worth your time to read and study regarding security evaluation on the macro level.

No doubt as far as this writer is concerned poor equity returns will follow with a very possible deep draw down of 45% to 60%.  Interest rates are so low when the correction does occur the Fed's are out of bullets unless they decide to make direct purchases of stocks.  DYI  is NOT forecasting that, so far that idea has been rejected by the Federal Reserve (thank goodness).  Once the selling starts, along with margin liquidations, the floor will be long way down.  For those who have the temperament a modest short position of 5% to 10% using the Prudent Bear Fund is warranted.

DYI