Everywhere I turn these days, I see articles discussing how over-extended U.S. equity valuations have become. If I took a shot of mouthwash every time I came across an article that talked about U.S. equity valuations, I’d be Leaving Las Vegas, Nic Cage-style, minus Elisabeth Shue. I monkey-hammered the idea of valuation as a catalyst for an equity market drawdown several weeks ago, but I have more to say on the matter. This week it’s woodshed time for Mr. John Hussman.
I’ve come across Hussman’s commentaries before, and I swear he gets paid based on the number of times he says “overvalued.” Well, he’s back with a brand new commentary beating the same old dead horse, but this time he’s coined a new phrase to describe the S&P 500: “offensively overvalued.” In truth, Hussman isn’t the only guy buying into the myth that valuation moves markets, but he is one of the more outspoken on the topic. Not only that, his performance track record is an exemplary cautionary tale of what happens to a portfolio that uses “valuation” as a primary component in the investment process.
While I obviously can’t say for certain what this guy uses to make investment decisions, it’s not a stretch to assume that valuation is a core part of his process, given how much he writes about it. Hussman’s favorite measures of valuation have registered as “overvalued” since 2012, which might explain why his flagship fund is in the midst of a four-year, 32% drawdown. His best-performing fund has mustered a positive 0.44% annualized return over the last five years with an 8.4% drawdown, which is still ongoing. This means he’s underperforming the ING Direct Orange Account during a period of time when the “overvalued” S&P has returned 69% with just a 13% drawdown.
The point of this commentary is not to pick on the John Hussmans of the world, but to highlight the dangers of relying too heavily on valuation as part of your process. Valuation is not a catalyst for U.S. equity downside, and it can also lead you to miss great opportunities if you avoid markets simply because you believe they are “overvalued.”
Let’s not rely on narrative and valuations to drive our investment decisions; let’s instead be data-dependent, process driven and risk conscious.
The Real Risk
The primary risk factor that could derail the U.S. equity market’s ascent since the election is not a correction due to valuation, but rather a decline in the U.S. economic data.
U.S. GDP growth has accelerated for two straight quarters, and based on early data this year, it’s accelerating in Q1 as well. The economy is improving in all aspects across both the service and manufacturing sectors. Not only that, but consumer-specific data shows strength not seen in well over a year.
Since the Crisis bottom in March 2009, U.S. growth has undergone a complete cycle of accelerating to a peak and slowing to a trough on three different occasions. The three accelerations lasted an average of 15 months and the three decelerations lasted an average of 14 months.
We know January’s data was solid, which puts the U.S. at seven months of acceleration and counting. Given the post-Crisis precedent, we could see growth accelerate for as long as another six months before the slowdown occurs. This week we will get our first glimpse of February data, and we’ll start to see if the top is already in or if growth has at least one more month of upside.
The $64,000 question is: if the risk materializes and U.S. growth starts to slow, then what’s the downside and where is the opportunity?
Hussman and his ill-fated followers of valuation models are calling for anything from a 30% to a 50% correction. I, on the other hand, am not. If the U.S. falls into a recession, then a steep correction is definitely on the table, but we are months, possibly even a year, away from a recession being a real possibility.
Do you really want to miss opportunities for the next six to twelve months waiting on a recession that may not come? Remember, Hussman has been calling this market overvalued for years, and his returns reflect how well that’s worked out for him and his clients.
If U.S. growth starts to slow, don’t expect that the S&P will automatically follow. In fact, during the last three economic slowdowns, the S&P averaged a +7.3% cumulative return over the 14-month average duration, with a maximum drawdown of around 13%. So, while there is roughly twice as much potential downside as upside, the S&P still came through those slowdowns ahead of the game.
If we look further back, the data tells us that the S&P 500 posted positive returns in 57% of the quarters during which U.S. growth was slowing. Being data dependent tells us that it takes more than just a slowing of U.S. growth to materially impact U.S. equities. The data also tells us that Hussman and his ilk aren’t likely to get the market tumble they are looking for during 2017.
Just because the S&P has a history of weathering slow growth storms doesn’t mean there aren’t better opportunities during those time periods. If you want to know the best way to trade during waning U.S. growth, you need to look at one more fundamental factor: inflation.
If inflation continues to accelerate, as it is now, then the best U.S. market to be LONG is the utilities sector. U.S. utilities outperform all other equity sectors by an average of 200 basis points per quarter, and also carry the least amount of drawdown risk. On the flipside, you’ll want to avoid basic materials and financial stocks, because they carry the most drawdown risk. They generally deliver negative performance during quarters when growth is slowing and inflation is accelerating.
The other possible scenario during an economic slide is that inflation follows growth and tumbles too. If this occurs, you want to be LONG U.S. Treasuries and to avoid all things commodity-related. In a growth-slowing, inflation-slowing scenario, U.S. Treasuries have posted a positive return 65% of the time, and outperform all U.S. equity sectors. Growth and inflation slowing in tandem is kryptonite for commodities and commodity-linked stocks, which have lost ground in 70% of those quarters.
The Bottom Line
No one can argue that the S&P 500 is way overdue for a pullback. It has been four months since the S&P has experienced a 1% daily decline, seven months since even a 5% pullback and over a year since it declined 10%. But being due for a pullback doesn’t mean we are sitting on the precipice of another Black Monday. And if we are on the precipice, I can promise you that the market’s valuation isn’t going to be the catalyst that pushes us over the edge.
Using valuation to call for market crashes every week may lead to clicks, views and retweets, and in Hussman’s case it has inexplicably led to over $800MM in assets. But it primarily leads to anticipating market risks that don’t exist and missing opportunities for long stretches of time.
I’m not a value guy, so I’m not qualified to say whether the S&P’s current valuation should offend you or not. But I can tell you what is “offensively overvalued,” and that’s the management fees Hussman has collected over the last five years while the funds he manages on his clients’ behalf have been outperformed by postage stamps (up +8.8% since 2012 with no drawdown). If you’re looking to outpace Orange accounts and postage stamps over the next five years, then don’t hang your investing hat on market valuations.
Stay data-dependent, process driven and risk conscious, my friends.