John P. Hussman, Ph.D.
The upshot is this. Quantitative easing only “works” to the extent that default-free, low interest liquidity is viewed as an inferior holding. When investor psychology shifts toward increasing risk aversion – which we can reasonably measure through the uniformity or dispersion of market internals, the variation of credit spreads between risky and safe debt, and investor sponsorship as reflected in price-volume behavior – default-free, low-interest liquidity is no longer considered inferior. It’s actually desirable, so creating more of the stuff is not supportive to stock prices. We observed exactly that during the 2000-2002 and 2007-2009 plunges, which took the S&P 500 down by half in each episode, even as the Fed was easing persistently and aggressively. A shift toward increasing internal dispersion and widening credit spreads leaves risky, overvalued, overbought, overbullish markets extremely vulnerable to air-pockets, free-falls, and crashes.
As a side note, the reason I emphasize that the effect of QE is psychological is that one can calculate the impact that a given period of zero interest rates should have on the discounted value of future cash flows. I’ll say this again – if historically normal equity valuations and prospective returns are associated with short-term rates averaging, say, 4%, one can show with straightforward discounting arithmetic that the expectation of zero interest rates for 3-4 years will result in a justified 12-16% increase in valuations over and above historical norms. On valuation measures that are best correlated with actual subsequent S&P 500 total returns (and many popular measures are quite weak on that record), we presently estimate that the S&P 500 is about 115% above historical valuation norms.
Put another way, we estimate nominal total returns of less than 1.4% annually for the S&P 500 over the coming decade, with negative total returns over the next 8 years. So if one believes that zero interest rates are likely to persist for another 8 years, and that stocks should be priced with zero return or premium for risk, stocks are probably fairly valued. If one believes that zero interest rates are likely to persist for another three decades, but stocks should be priced with normal historical risk premiums over and above risk-free rates, stocks are also probably fairly valued. In every other universe, stocks are about double historically normal valuations, even adjusting for the likelihood of several more years of zero short-term rates.DYI Comments: If one is to believe in averages and markets regressing back to their mean (which DYI ardently believes in!) when they overshoot the U.S. market as measured using dividends is 130% above historical valuation norms not 115%. The math is easy and straight forward: (53 - 23) / 23 x 100 = 130%.....The 53 is our current price to dividends (1 / 1.87% dividend yield S&P 500) and 23 is the long term average since 1871 (4.42%) expressed as price to dividends as reported by Multpl.com.
Anyway you look at this market it has become nothing more than a speculators market who are buying in hope of selling at an even higher price to another speculator. It is all fun and games until someone gets hurt and sentiment changes to that southern direction. In the meantime it is possible for the market to be pushed higher due to our lower oil prices. If this occurs our sentiment indicator will go back to a secular top (year 2000) as once again the ten year estimated average annual return will be NEGATIVE!
Market Sentiment
Capitulation
THE GREAT WAIT CONTINUES!
DYI
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