The Line Between Rational Speculation and Market Collapse 

John P. Hussman, Ph.D.

The Shiller P/E (S&P 500 divided by the 10-year average of inflation-adjusted earnings) is now 27, versus a long-term historical norm of 15 prior to the late-1990’s bubble. Importantly, the profit margin embedded into the Shiller P/E is currently 6.7% versus a historical norm of just 5.4%. The implied margin is simply the denominator of the Shiller P/E divided by current S&P 500 revenues (the ratio of trailing 12-month earnings to revenues is even higher at 8.9%). As I showed in Margins, Multiples and the Iron Law of Valuation, taking this embedded margin into account significantly improves the usefulness and correlation of the Shiller P/E in explaining actual subsequent market returns. With this adjustment, the margin-adjusted Shiller P/E is now nearly 34, easily more than double its historical norm.  

 This fact is important, because the Shiller P/E averaged 40 during the first 9 months of 2000 as the tech bubble was peaking. But that Shiller P/E was associated with an embedded profit margin of only 5.0%. Adjusting for that embedded margin brings the margin-adjustedShiller P/E at the 2000 peak to 37.

Current equity valuations provide no margin of safety for long-term investors. One might as well be investing on a dare. It may seem preposterous to suggest that equities are literally more than double the level that would provide a historically adequate long-term return, but the same was true in 2000, which is why the S&P 500 experienced negative total returns over the following decade, even by 2010 after it had rebounded nearly 80% from the 2009 lows. Compared with 2000 when we estimated negative 10-year total returns for the S&P 500 even on the most optimistic assumptions, we presently estimate S&P 500 10-year nominal total returns averaging about 1.3% annually over the coming decade. Low interest rates don’t change this expectation – they just make the outlook for a standard investment mix even more dismal – and the case for alternative investments stronger than at any point since 2000. I’ll repeat that if one associates historically “normal” equity returns with Treasury bill yields of about 4%, the promise to hold short-term interest rates at zero for 3-4 years only “justifies” equity valuations 12-16% above historical norms. Again, at more than double those historical norms, current equity valuations provide no margin of safety for long-term investors.

DYI