Financial guru John Hussman is wrong about "Valuations and Clarity" - 2-Jan-2010 - Generational Dynamics

I normally don't want to pick on John P. Hussman, since he's one of the better financial analysts, and to be fair, he is a lot less Pollyannaish than most of the others. But his 21-Dec newsletter, "Clarity and Valuation," contains remarks about price/earnings ratios (also called "valuations") that are far off base, and introduce a new tool with which to defraud investors.

As regular readers of this web site are aware, price/earnings ratios have been above average since 1995. (See "How to compute the 'real value' of the stock market.") From about 2004-2007, the P/E ratio was around 18-20, still very expensive, and still above the historical average of about 14. (See the chart at the bottom of the home page of this web site.)

But after the credit crisis began in late 2007, earnings began falling, and P/E ratios started increasing. With the stock market rally in 2009, P/E ratios have been astronomically high, near 100. This is a remarkable and unique historical development, but you never hear or read about this on CNBC or in the Wall Street Journal. These mainstream sources make their money by advertisements from financial institutions, and financial institutions make money by selling investments, and talking about a P/E ratio close to 100 would turn off investors, so no one wants to talk about P/E ratios.

Early in 2009, we saw the ridiculous spectacle of financial commentators talking about P/E ratios based on "operating earnings," a phony earnings number that ignores many expenses. But it satisfied the needs of financial institutions who wish to make commissions and fees by investing other people's money. (See "Wall Street Journal sharply revises its fantasy price/earnings computations.")

By today, even the P/E ratios based on phony operating earnings are around 30, which is also astronomically high, so financial institutions can no longer even use those numbers.

'Normalized Earnings' to the rescue

Now we have Hussman's analysis which brings a brand new level of disinformation to the discussion. He discusses an even phonier kind of earning computation, called "normalized earnings":

"On the basis of normalized profit margins, the average price/earnings ratio for the S&P 500, prior to 1995, was only about 13. Higher historical “norms” reflect the addition into that average of extremely high “recession P/Es,” based on dividing the S&P 500 by extremely low, but temporarily depressed earnings. For example, the P/E for the S&P 500 currently is 86, because earnings have been devastated, but it would be foolish to take that figure at face value, and equally foolish to work it into a historical “average” P/E. The pre-1995 norm of 13 for price-to-normalized earnings is important, because at present – and again, we are not using current depressed earnings, but properly normalized values – the S&P 500 P/E would currently be over 20. That's higher than 1987 and 1972, and about even with 1929. Of course, valuations have been regularly higher in the period since the late 1990's (and not surprisingly, subsequent returns, even after the recent advance, have been dismal overall, with the S&P 500 posting a negative total return for the past decade)."

According to Investopedia, "normalized earnings" are: "earnings adjusted for cyclical ups and downs in the economy" or "earnings adjusted to remove unusual or one-time influences."

In other words, you start from the phony "operating earnings," you remove even more expenses, and then you pretend that there was never a bubble. It's the height of stupidity and insanity, but that's the norm these days. If you don't like a number, then make up your own, and use that number to defraud investors.

According to Hussman, the high P/Es are "based on dividing the S&P 500 by extremely low, but temporarily depressed earnings. For example, the P/E for the S&P 500 currently is 86, because earnings have been devastated, but it would be foolish to take that figure at face value, and equally foolish to work it into a historical 'average' P/E."

So he uses this magic "normalized earnings" figure, which somehow gets the P/E ratio from 86 (for reported earnings) or 30 (for operating earnings) down to 20. Seeing this go on literally takes my breath away.

Bubble vs post-bubble earnings

Hussman says that earnings have been "temporarily depressed" and "devastated," but it would be "foolish" to trust these earnings values. (Presumably, it's less foolish to use phony "normalized earnings.")

Of course earnings have been devastated. The credit and real estate bubbles have ended, and they're still collapsing. The high earnings were a product of the bubbles. Today's "devastated" earnings are a perfectly normal reaction, as the bubbles collapse.

These are the figures used to compute the S&P 500 P/E ratio. For example, earnings per share for the year 2007 were $66.18, and the S&P index on 31-Dec-2007 was 1468.36, and so the P/E index at that time was 1468.36/66.18 = 22.18, well above the historical average.

I've split the values into four columns, so you can see what happened. Before the dot-com bubble, a typical share earned around $20. The dot-com bubble pushed that up to $50 per share in 2000. The credit and real estate bubbles pushed the value of up $81 by 2006. Then earnings fell to $14.88 per share in 2008.

Now, $14.88 is certainly a "devastated" value, to use Hussman's word, but is it really "foolish" to take it at face value? It's comparable to the value $15.97 in 1991. That's not so long ago.

Law of Mean Reversion

In fact, the value $14.88 is quite a reasonable value at this time, since it reflects the end of the credit and real estate bubbles. The future estimates of $45.50 and $61.01 are so unreasonable as to be fantasies, since they assume that the bubbles will be restored.

If you fit the last century's earnings into an exponential growth curve, and extrapolate that curve to 2009, then you get a trend value for about $41 for 2009. So in the absence of a bubble, you should not expect earnings per share to be above $41 for some time to come.

But it's a lot worse than that, since earnings have to fall much farther, to compensate for the bubble highs. This is the Law of Mean Reversion, which says that if a value is well above trend for many years, then it has to fall well below the trend value for roughly the same number of years. This is simple math, since it says that the average growth rate in the future will equal the average growth rate in the past.

During bubbles, there are always people who say "This time it's different." We saw this in the housing bubble, where I heard financial analysts, economists and journalists say, "Housing prices can't go down -- people have to live somewhere," and "Banks won't foreclose -- it's not in their interest to do so" and "These housing construction firms know what they're doing, and they wouldn't be building houses if it were just a bubble."

All of these arguments proved to be completely wrong, but financial analysts, economists and journalists are apparently too dumb to learn from their mistakes.

Let's see if we can give an intuitive explanation for why the earnings per share value has to fall well below the trend value (currently $41) for a long time to come.

This is why the Law of Mean Reversion works, and why it must always work. The bubble creates jobs, factories, and businesses that can no longer survive in the new world of reduced demand. This feeds on itself, and collapses the bubble even further.

The data value (earnings, in this case) can't simply return to the trend value that it would have had, if there'd been no bubble, since the bubble used up resources that have to be replenished, and that imposes costs and depresses the data value after the bubble bursts.

This is what ALWAYS happens, no matter how many times analysts claim, "This time it's different." It's NEVER different.

Some people hope that government stimulus packages can change things, but they can't change the fundamentals, and sometimes make things worse. The "cash for clunkers" program caused a temporary surge in car sales, but presumably only "borrowed" sales from months after the program ends. Many economists believe that the $75 billion program to protect homeowners from foreclosures has done more harm than good, since it causes homeowners to waste money on homes they're going to lose anyway. And in China, stimulus money is being used to create ghost towns and empty skyscrapers, pushing the price of real estate up in a new bubble. (See "Skyrocketing real estate prices in China alarm officials.")

The use of "normalized earnings" by Hussman and others is a bizarre and disturbing new development by financial analysts and journalists to hide what's going on.

But the underlying fundamentals have not changed. Since 1995, we've had a dot-com bubble, a housing bubble, a credit bubble, and a stock market bubble. We have not nearly begun to pay the full price for those bubbles, as they continue to collapse. (This article was lightly edited for clarity on 3-Jan.)

Generational Dynamics Web Log for 2-Jan-2010
Financial guru John Hussman is wrong about "Valuations and Clarity"

'Normalized Earnings' to the rescue

Bubble vs post-bubble earnings

Law of Mean Reversion

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Generational Dynamics Web Log for 2-Jan-2010 Financial guru John Hussman is wrong about "Valuations and Clarity"

'Normalized Earnings' to the rescue

Bubble vs post-bubble earnings

Law of Mean Reversion

Web Log Pages

Generational Dynamics Web Log for 2-Jan-2010
Financial guru John Hussman is wrong about "Valuations and Clarity"