Christine Benz: Hi, I'm Christine Benz for Morningstar.com. I'm here at the Morningstar Ibbotson Conference and today I had the opportunity to sit down with John Hussman he runs very wide ranging portfolios and we got his opinions on a broad swath of different asset classes.
So let's talk about your long range forecast for stock returns.
John Hussman: Sure, well one of the things that we do and we have a lot of this on the Hussman Funds website in terms of the actual quantitative methods that we use and showing their historical records and so forth, is to take a look at the 10 year perspective return for the S&P 500.
If you look at S&P 500 earnings, even though there is a lot of volatility you can chart those back to the depression and you'll see that historically the peaks from cycle-to-cycle have been pretty well bounded by a 6.3% annual growth rate and that hasn't changed even during the inflation period of 70s, during World War II and during some of the smaller wars. So we've got a pretty good idea of S&P 500 earnings over the long run that they pretty well track nominal GDP, because nominal GDP has been about the same growth rate. What we can do with that is we can form these longer term projections for the S&P they are best for about seven to 10 years. And back in 2009, early 2009 stocks were priced briefly to return a little bit more than 10% annually over the decade ahead.
Benz: So if you've been a buyer then, that was a good thing.
Hussman: In hindsight that was a good thing. In the depression 10%, 12% wouldn't have worked out too well. Once stocks had dropped to the point where they were priced to deliver 10% or 12% they actually went on to lose two-thirds of their value. So even though the 7 to 10 year might have been okay, the shorter term pressures were terrible in the depression.
There are certainly sometimes where stocks have been priced to deliver significantly beyond that. If you look at '74 and 1982, both of those points stocks were priced to achieve total returns annually about 20% compounded. So there are clearly periods where stocks have been priced to deliver enormously good returns there are periods where prices have been expected to essentially gain nothing over a decade. If you look at 2000, we had a negative 2% expected return using these same models and again these fit pretty tightly over history. And where they don't, in other words where stocks have outperformed what you would have expected, you typically find that subsequently they dramatically underperform like we saw after the 2000 peak. When stocks have underperformed what you would have expected which was the case in the decade leading up to 1974 you find that stocks have been great values and perform much better.
Right now, given the advance that we've had our expectation is that stocks are priced, the S&P broadly, is priced to achieve total returns averaging about 3.5% annually. Not a great return, but it's actually still better than it was at the 2007 peak and certainly better than it was at the 2000 bubble peak. So for long-term investors that's a consideration. The problem with valuations is that again 7 to 10 years is really the horizon over which valuations exert their effect and they don't have a lot to do with shorter term returns.Read Full Transcript
If we go roughly from a 3.5% expected return to a 2.5% expected return for the next decade what that essentially translates into is another 10% advance in stocks. And it's not something we can rule out over the short term. So broadly, longer term I think investors have to realize that there is some risk there of not getting particularly high returns over the shorter term, those things don't bite us hard.
What I talked about at the Ibbotson Morningstar Conference are some of the shorter term factors that people would be might find helpful to look at. When we look at various rules of thumb like Don't Fight the Fed, Don't Fight the Tape. If you try and quantify Don't Fight the Fed virtually any way it's actually not a very useful rule it certainly wouldn't helped you avoid some really major declines. There is no way you couldn't say that the fed was not accommodative in 2008 for example and the market just fell apart. So, Don't Fight the Fed is helpful but it's not decisive.
Don't Fight the Tape is actually better, but you still have certain pockets where Don't Fight the Tape were even when stocks are generally rising it doesn't work too well. Don't Fight the Tape will help you to avoid huge draw downs that's a main thing it will do. But there is one type of draw down that doesn't help with which is when stocks are very overvalued they are overbought, sentiment is over bullish. So, you look at general bullishness surveys and so forth and they are well above 45 or 50 and interest rates are rising you get those together and what you tend to get is the market hitting these little marginal new highs and then it gets you get an air pocket and that clears and then you might have a little more upside.
That's really where we are right now. My suspicion is that there is some air pocket that will get into that will clear some of this and then we may or may not have a continuation to the upside but it really depends on how much we can clear that without breaking the Don't Fight the Tape thing. If you start getting real significant breakdowns in a lot of different markets then you've got a combination of rich valuations and breaking down internals and that's usually where investors have seen trouble.
This environment were in, is not one where investors can say "well stocks are priced to achieve great returns so I can just sort of put them aside." It's an environment where we know this -- in our view stocks of prices to deliver relatively weak returns and we factor in things we look at arguments about repurchases and dividend retention and all that and work those considerations in to multiple models that we use and we don't get much difference in terms of the returns. So, it's something where investors should be aware that stocks are -- stocks broadly speaking our prices to achieve relatively modest long-term returns.
One other thing that I talked about yesterday was the link between low expected returns and what people call tail risk. If you look at periods where stocks have been priced to achieve very strong returns like 20% which you saw in the 70s at various points in 1982. The higher the expected 10-year return is the smaller the maximum draw down that you've gotten over the next five years. In other words you don't get hit very hard in terms of the maximum loss that you might sustain over the next five years.
On the other hand when returns, when expected returns are very low it doesn't mean that stocks are going down right away. But what it does do is it expense the depth of those possible draw downs back in 1999 stocks were priced to deliver poor returns but that didn't stop them they went up to 2000. What was the problem is that tail risk was very high and we saw that roll out in 2001, 2002 as the market dropped by more than half. Same thing in 2006, stocks were priced to deliver relatively poor returns they just kept going through 2007 but that tail risk eventually caught up with it.
So, what my view is for investors is not to say stocks are going down right now, you got to get out a stocks, you got to hold all cash. My view is that we have to be aware of the long-term returns that are likely priced into the investments we hold and be aware of how much risk we're willing to take and be aware of how quickly we believe we can move. And for the broad investing public I don't think you can wait until the last minute to make any change at all I think you generally try and be proportional about your risk taking if expected returns are very high relative to the potential risks you can be very aggressive, if expected returns are more modest than doesn't mean you have to get out but you might want to curtail your risks little.