20131216_hussman_funds - the coming retreat in corporate earnings

8/13/2019 20131216_Hussman_Funds - The Coming Retreat in Corporate Earnings

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The Coming Retreat in Corporate EarningsHussman Funds

By John HussmanDecember 16, 2013

John Hussman will be speaking at the Wine Country Conference held in Sonoma, CA on May 1 st and 2 n2014. Net proceeds from the conference will go to the Autism Society of America for grant requestsfocusing on high-impact programming for individuals on the autism spectrum and their families. Morenformation at www.winecountryconference.com .

The iron law of investing is that an investment security is nothing more, and nothing less, than a claim onsome expected str eam of future cash that will be delivered into the hands of investors over time.

In some cases, the future payment is simple, like a bond that promises to pay a lump sum of $100 ten yearsfrom today. Pay $38.55 for that bond today, and you can expect a 10% annual rate of return on your money.Pay $67.56 for that bond today, and you can expect a 4% annual rate of return. Pay $82.03 and you canexpect a 2% annual rate of return over the next decade. The more you pay today for an expected futureamount, the lower your implied rate of return. Conversely, given any required rate of return you seek onyour investment, you can work backwards and figure out the present value that youre willing to pay.

In some cases, the future payment is complicated, like an option that promises to pay you the differencebetween the price of a stock and some strike price, provided that the actual price gets past the strike pricein the next few months. For that security, you have to compute the payoff that the option might deliver atevery price beyond the strike price, multiply each of those values by the estimated probability the price will getto that particular point, and then discount everything back to present value. To simplify all of that, optionpricing models make various assumptions about probability distributions, volatility, and other considerations.

But simple, or complex, or anywhere in the middle, an investment security is nothing more, and nothing less,than a claim on some expected stream of future cash that will be delivered into the hands of investors overtime.

In practice, few investors want to estimate a whole stream of future cash f lows, so they take shortcuts.Those shortcuts, however, are entirely dependent on the assumptions one is willing to make. Suppose youhave a security that is expected to produce a very smooth stream of future payments over time, growing atsome constant rate. In that case, the current payment is really all you need to value the security because itis representative of the whole stream. On the other hand, if the current payment is not representative of thewhole stream, youre in trouble.

That warning applies to price/earnings ratios, price/10-year earnings ratios, price/forward earnings ratios, andvirtually every other valuation measure that takes any shortcut whatsoever. Treat your fundamental asrepresentative when its not, and it doesnt matter which measure youre using youre going to get amisleading estimate of valuation.

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Applying a seemingly reasonable price/earnings multiple to cyclically elevated earnings is a repeatedmistake, and is unfortunately exactly the same one that I waved my arms to warn about in 2000 (One of thhard lessons that investors will learn in the coming quarters is that technology stocks are actually cyclicals)and 2007 (You wouldn't buy a lemonade stand by extrapolating the profits it earns in August) to no avail.

In our own work, we rely on a broad range of valuation measures. Many of them embed various adjustmentsto capture the fact that earnings, dividends and other value-drivers are often not very representative of theentire future stream. A few very simplified models that still have a near-90% correlation with actualsubsequent market returns are presented in Investment, Speculation, Valuation and Tinker Bell . Because thShiller P/E (the S&P 500 divided by the 10-year average of inflation-adjusted earnings) is simple to calculateand broadly quoted, I often mention it in these weekly comments at least it has the virtue of being lessvulnerable to year-to-year swings in earnings over the course of the business cycle. But our work isemphatically not driven by the Shiller P/E, our valuation approaches go far beyond the Shiller P/E, and eventhe Shiller P/E is at best a shorthand measure of market valuations.

To understand our deeper concern, its important to focus on the word representative. Any valuation

measure like price/X is only useful to the extent that X is representative of the very long-term stream offuture cash flows. As Ill detail below, the problem at this moment is that profit margins are about 70-80%above their historical norms; there is a century of history (including the experience of the most recentdecade) to demonstrate that elevated profit margins have always normalized over time; we know why theynormalize over time; and we already observe pressures that are likely to force this sort of normalization overthe coming 2-4 years.

In short, the earnings measures typically used in Wall Streets valuation work are more unrepresentative thanat any time in history, and investors are vastly overpaying for stocks as a result. In this context, rememberthat stocks are presently 50-year duration instruments. Even if margins were to remain elevated for severalyears more (which is unlikely), it would not follow that present earnings are representative of the long-term

stream that is actually relevant for pricing stocks.The coming retreat in corporate earnings

We should begin with an observation. If one examines the historical data, there is a very weak relationshipbetween year-to-year changes in earnings and year-to-year changes in the stock market. This lack ofrelationship partly reflects the fact that stock prices often recover from recessions quite briskly well beforeearnings advance, and stock prices often collapse well before earnings do. But even accounting for theseleads and lags, the relationship between cyclical fluctuations in the S&P 500 and S&P 500 earnings is simplynot very strong.

My concern at present is emphatically not simply a concern about the near-term direction of earnings, or anyassumption that stocks must closely follow earnings. Rather, my present concern is much more secular innature. It can be expressed very simply: investors are taking current earnings at face value, as if they arerepresentative of long-term flows, at a time when current earnings are more unrepresentative of those flowsthan at any time in history. The problem is not simply that earnings are likely to retreat deeply over the nextfew years. Rather, the problem is that investors have embedded the assumption of permanently elevatedprofit margins into stock prices, leaving the market about 80-100% above levels that would provide investorswith historically adequate long-term returns. An equivalent way to say this is that stocks are currently at

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levels that we estimate will provide roughly zero nominal total returns over the next 7-10 years, withhistorically adequate long-term returns thereafter

There are several ways to look at profit margins, with varying implications though all negative for theextent of retrenchment that can be expected in corporate earnings in the coming 2-4 year period. The firstchart below presents a rather pure mean-reversion argument. The blue line shows the ratio of corporateprofits to GDP, which is currently more than 80% above its historical norm. The red line shows the annualgrowth in profits over the following 4-year period (inverted). Put simply, high profits/GDP are associated withweak subsequent profit growth, while depressed profits/GDP are associated with strong subsequent profitgrowth. At present, the extreme profit/GDP ratio we observe here is consistent with expectations of a 22%annual contraction in profits over the coming 4-year period which would imply a roughly 63% cumulativecontraction in profits from present levels. My impression is thats probably too aggressive an expectationexcept as a temporary trough. A more reasonable expectation, in my view, would put corporate profits downabout 10% annually over the next few years.

Part of the reason we would expect a more muted contraction in profit margins is the recognition thatgovernment budget deficits are likely to remain relatively high in the coming years. A simple way to think of



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the circular flow of the economy is that corporations produce output and pay salaries, whileworker/households use that income to purchase output and consume. In recent years, weak employmentpaired with massive government deficits have introduced a wedge into the circular flow, allowing wages andsalaries to fall to the lowest share of GDP in history, even while households have been able to maintainconsumption as the result of deficit spending, reduced household savings, unemployment compensation andthe like.

The deficits of one sector emerge as the surplus of another. As a result, deep deficits in combinedgovernment and household saving have created a mirror-image surplus of corporate profits in recent years.The chart below shows the relationship between 3-year changes in government and household savingsversus 3-year growth in corporate profits (partly overlapping, but partly subsequent as inventories and otherfactors can induce slight lags). The upshot of this chart is that recent improvements in government andhousehold savings are already working their way through the economy, and are likely to be observed as acontraction of corporate profits in the next few years.

Yet another way to think about corporate profits is presented below. Here, we observe that corporate profitsare linked to the difference between output prices and input costs, where the majority of those inputs



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represent labor. The blue line in the chart below shows the annualized 6-quarter growth of the GDP deflator(an economy-wide price index for output) less the growth of unit labor costs (the amount that must be paid aslabor cost in order to produce one unit of output). The red line shows the 6-quarter growth of corporateprofits. The relationship here should be clear. Since 2009, and until recently, increases in the GDP deflatorover and above unit labor costs were nicely supportive of corporate profit growth. Those growth rates havereversed, with unit labor costs now growing faster than the GDP deflator. This places downward pressure oncorporate profits, consistent with what we expect from based on an analysis of profits from other,complementary perspectives.

Given this context, it may not be a great surprise that were observing an enormous surge of negative

earnings pre-announcements from companies that will shortly be reporting earnings for the fourth quarter(chart h/t ZeroHedge ). Last week, Thomson-Reuters reported: The 11.4 negative to positive guidance ratiois the most negative on record by a wide margin. While the deterioration in the earnings outlook is paced bya surge in the number of negative pre-announcements, the spike in the negative/positive ratio is aggravatedby a collapse in the number of positive earnings pre-announcements to a relatively small handful of S&P 500companies. While we shouldnt interpret the spike too strongly, its difficult to find much encouragement inthe imbalance between negative and positive surprises.

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How to evaluate new valuation indicators

Keep in mind that the proof of any valuation measure is not simply in its construction, and not simply in itselegance. The proof of any valuation measure is the extent to which it is related to actual subsequent mark

returns. When the market becomes richly valued, hardly a week goes by especially at points like 2000,2007 and today that someone doesnt trot out some new adjusted valuation measure that proposes tocorrect for some presumed defect in existing measures (usually by justifying overvalued prices as just fine). Ienthusiastically support careful valuation research provided that the resulting measures are overlaidagainst actual subsequent total returns. This is almost never done. The rule is simple: with any novelvaluation measure, analysts should provide evidence that it is closely correlated with actual subsequent market returns in numerous market cycles across history.

We saw an interesting example of this last week, as a Wall Street analyst (whom I disagreed with just asstrongly in 2000) trotted out a measure called a normalized earnings yield gap essentially the differencebetween the Treasury bond yield and the earnings yield of the S&P 500, based on 10-year average earnings.

In this construction, high levels are bad because Treasuries have a higher yield than stocks, while lowlevels are good because bond yields are low relative to earnings yields. The basic argument was thatpresent levels dont look bad at all. The problem, if one cared to actually examine the data, is that thismeasure has a ridiculously poor relationship with actual subsequent returns in the S&P 500 (in excess ofTreasury returns). Remember the rule: with any novel valuation measure, analysts should provide evidencethat it is closely correlated with actual subsequent returns in numerous market cycles across history. Socalled improved valuation methods with historical records like the one below are useless noise.



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We see the same sort of novelty in a flurry of articles with proposed adjustments to other valuationmeasures that have performed perfectly well up even into the present market cycle. Yes, several reliablevaluation measures have hovered at much higher levels since the late-1990s than were generally seenhistorically. But that in itself is not evidence that these historically reliable valuation measures are broken.It matters that those high valuations have been associated with a period of more than 13 years now wherethe S&P 500 has scarcely achieved a 3% annual total return.

The rule is worth memorizing because it protects against the perennial argument that the old valuation

measures no longer apply and this time is different heard at every major valuation peak in history. AsJohn Kenneth Galbraith wrote decades ago about the advance to the 1929 peak It was still necessary toreassure those who required some tie, however tenuous to reality as in all periods of speculation, mensought not to be persuaded by the reality of things but to find excuses for escaping into the new world offantasy."

The rule: with any novel valuation measure, analysts should provide evidence that it is closely correlatedwith actual subsequent market returns in numerous market cycles across history. Needless to say, one



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should also question the ones where data does not exist prior to the most recent cycle, or where noadjustment would have occurred in anything other than the most recent cycle. We saw this a great deal inthe late-1990s tech bubble its a version of this time is different.

The following charts offer some idea of what reasonably useful valuation metrics should look like againstsubsequent returns. Weve got a dozen others just like these, using entirely different fundamental measures.The challenge of any new adjusted valuation indicator isnt just to make investors comfortable withwhatever heights the market has scaled, but to demonstrate effectiveness in decades of data. At present, thechallenge is also to address the question of why other historically reliable and varied measures which sendexactly the same message at present are all wrong simultaneously.



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Frankly, most debates about valuation methods can be easily settled by the data, but the same argumentsemerge at every market top: Its different this time. The critics are wrong. Profit margins are fine. Valuationsshould be higher. And stocks are going up. Its a useful reminder that what may have been an unsettleddebate on these points in 2007 was quickly followed by a 55% plunge in the stock market, and in 2000 by a50% plunge.

Ill be the first to agree that the uncompleted half-cycle since the 2009 leaves me open to criticism on somefronts. But it's important to observe that our valuation measures were favorable in late-2008 and 2009(see Why Warren Buffett is Right and Nobody Cares ). Criticize my fiduciary inclination in 2009 to stress-testour approach against Depression-era outcomes, which resulted in a very awkward transition in methodsduring this half-cycle. Criticize my unwillingness to rest our security on superstitious faith in Fed policy thathas no transmission mechanism except to encourage speculative yield-seeking. But dont ignore themessage that reliable valuation measures are screaming here. They havent missed a beat.

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A technical note on valuation multiples and discounting models

The first valuation model most finance students learn is the dividend discount model. Suppose that asecurity throws off a dividend every year, growing at rate g forever, and is so long-lived that any terminalpayment essentially has a present value of zero. In that case, the value of the security works out to D/(k-g)where k is the rate of return demanded by investors. With a $2 dividend, a long-term 10% expected returnforever, and a 6% growth rate, youll get a $50 fair value for the stock price. Indeed, given assumptionsabout g and k, investors can forget the math. In a nice world like that, the fair dividend yield is always 4%.The fair price/dividend ratio in that world is always 25.

The crucial point here is that a valuation multiple is a shorthand for a proper, fully-specified discounted cashflow model. A seemingly harmless multiple actually embeds all sorts of assumptions about prospectivereturns, growth rates, and the representativeness of the initial fundamental. In the example above, if bychance the company pays a special dividend thats 80% above the norm for a few years, and investorscarelessly slap a price/dividend multiple of 25 on that dividend, theyre going to vastly overpay.

This is essentially what investors are doing here. What investors think of as a typical price/earnings ratioactually embeds numerous assumptions about revenue growth rates, profit margins, dividend payout rates,return on reinvested capital and other matters. Most importantly, it embeds an assumption that this yearsearnings are fully representative of the long-term stream.

A note on buybacks while the infinite dividend discount model is very sensitive to small changes inassumptions in the first place, one variation that should never be made using per-share data is to add stockbuybacks as if they are also dividends. Values and fundamentals for the S&P 500 are computed on a pershare basis that already accounts for buybacks, capturing their effect on both the level and the growth rateof index dividends (which can be demonstrated with straightforward but tedious arithmetic). Buybacks at richvaluations (low k) are harmful, and adding buybacks in a per-share model represents double counting.

Moreover, buybacks are often simply a way to reduce the dilution that would otherwise result from grants ofshares corporate insiders and employees. The general rule of thumb is that buybacks are beneficial only atvaluations where investors would be well-served reinvesting their dividends into a companys stock on theirown behalf.

As for dividend discount approaches, they can be very useful when they are properly computed. Theseapproaches supported our concerns at the 2007 peak (see Fair Value 40% Off ). But they are alsovulnerable to misuse by analysts who arbitrarily choose k and g to be so close that virtually any price can beustified the Dow 36,000 argument at the 2000 peak was one spectacular consequence of this misuse.

(c) Hussman Fundswww.hussman.net

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20131216_hussman_funds - the coming retreat in corporate earnings

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