Why investors could face seven years of terrible returns: Maley

Investors may be joyfully celebrating the recent surge in US share markets, but Dr John Hussman warns the next seven years are likely to produce abysmal returns.

In his latest Weekly Market Comment, Hussman argues that when share market valuations become overly rich, long-term returns are inevitably disappointing.

He points out that over the past 10 years, the S&P 500 achieved a total average annual return, including dividends, of -0.03%.

But instead of seeing this as an investment anomaly, Hussman argues that this poor return was entirely predictable in the late 1990s, if investors had looked at historical relationship between valuations and subsequent returns.

What’s more, Hussman argues that share markets are again severely overvalued, which means that investors again face a protracted period of poor returns. As he puts it, “stocks, from their current valuations, will achieve negligible returns in the coming five to seven years”.

Hussman argues that in the entire history of the share market, before the valuation bubble that emerged in the mid-1990s, the dividend yield on the S&P 500 fell to 2.65% on only three occasions. These dates were August 1929, December 1972 and August 1987. These dates ring a bell? They should. As Hussman notes, these were “the peaks prior to the three worst market plunges of the 20th century”.

Before the surge in the share market in the mid-1990s, the mid median dividend yield on the S&P 500 was about 4.1%. This share market surge was followed by a decade of dismal returns for investors. Since that period, the dividend yield on the S&P 500 has regularly dipped below 2.65%, and last week dipped to just 2%.

Hussman argues that with dividend yields at such depressed levels, the likely return from the S&P over the next seven years is likely to be around 0.07%.

As Hussman notes, this leaves investors with a terrible problem. “Given that the yield on the S&P is now below 2%, it is essential for investors to recognise that they now rely on the achievement and maintenance of sustained bubble valuations in the years ahead.”

“Unless investors believe that bubble valuations can be maintained indefinitely, they can expect little but abysmal returns over the coming five to seven year period.”

Now, as we’ve seen in the past, it’s entirely possible for share markets to maintain bubble valuations for very long. But for this to happen, investors have to be willing to avert their eyes to the growing risks.

At present, this is exactly what’s happening. Hussman notes that last week the International Monetary Fund released a dour warning on the global financial system where it noted that conditions “now have the potential of jumping from benign to crisis mode very rapidly”. But the report caused little consternation. As Hussman notes, “at least for now, investors evidently could not care less”.

Investors are also turning a blind eye to the international banking system, which Hussman points out bears an uncanny resemblance to a Ponzi scheme, in that the underlying cashflows are not enough to meet the total amount of the debt.

As he notes, there is a huge difference between the liquidity of a Ponzi scheme, and its solvency. “A Ponzi scheme may very well be liquid, as long as few people ask for their money back at any given time. But solvency is a different matter – relating to the ability of the assets to satisfy the liabilities.”

The way to prevent Ponzi schemes is to ensure that the businesses are properly audited. But, Hussman argues, this is not what is happening with the US banking system.

“Unfortunately, banks are now allowed to value many of their assets with substantial discretion, and the models may be no better than the ones that assigned investment-grade ratings to sub-prime loans.”

And that’s without mentioning the dark clouds gathering over the US housing market. As he points out, “numerous banks have been abruptly suspending foreclosures, because it is increasingly evident that in many cases they do not even have documentation of the underlying mortgages. It is difficult to see how this can possibly inspire confidence that the credit crisis is over and everything is back to normal.”

Hussman offers little apology for his act in casting a pall over the share market festivities. “We’d love to be bulls, scampering happily about. But that would be helped if stocks were priced appropriately and if there was not a large anvil suspended on a fraying string overhead.”

This article first appeared on Business Spectator.