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Hussman: The Market Is Significantly Overvalued

Ryan Leggio

Ryan Leggio: Hi. I'm Ryan Leggio. I'm a Mutual Fund Analyst at Morningstar. John Hussman, the manager of Hussman Strategic Growth and Hussman Strategic Total Return, wrote a very pointed letter on Monday concerning the economy and what that means for investors generally. Hi, John, thanks so much for joining us today.

John Hussman: Hi, Ryan.

Leggio: Well, let's turn to your letter, and I wanted to read a couple of the passages specifically. For viewers of the video, they can find the entire letter in its entirety with the link right under the video, and the letter is entitled, "Recession Warning" and here are the two passages that really stood out for me, John, which I wanted to ask you about.

The first is the first sentence of the letter, "Based on evidence that has always and only been observed during or immediately prior to U.S. recessions, the U.S. economy appears headed into a second leg of an unusually challenging downturn." That was the first sentence that really caught my eye.

And the second one is follows, "In recent months, I have finessed this issue by encouraging investors to carefully examine their risk exposures. I'm not sure that finesse is helpful any longer. The probabilities are becoming too high to use gentle wording." And here's really the kicker, you write, "Put bluntly, I believe that the economy is again turning lower, and that there is a reasonable likelihood that the U.S. stock market will ultimately violate its March 2009 lows before the current adjustment cycle is complete."

Question for you, John, why are you so worried right now?

Hussman: Well, in terms of recession risk, the syndrome of indications that we're seeing right now are indications that we've only seen during recessions or immediately prior to new downturns in the economy. This is the same set of indicators that we used in November 2007 when we got that recession warning and reported that, and I did a CNBC interview, which is rare for me, when we did that, because I thought it was an important thing to underscore for investors. And we saw the same set of signals in October of 2000 prior to that breakdown in the economy and the stock market.

So, these are basically forward-looking indicators, and it's a syndrome of things. We've seen the yield curve really contract, 10-year yield has dropped from 4% to 3%. We've seen credit spreads blow out again. We've seen a number of the leading, more useful leading indicators of economic activities like the ECRI Index really turn negative quickly over the last several weeks. We've also got a stock market that's below its level of six months ago. When you combine a number of these observations--and we list them on the website and we've done this for more than a decade now--when we see these conditions, and this is the third time we've seen them in a decade, we have seen recessions. We've seen the economy turn down.

At this particular point in time, I don't think that the economy is in a situation where it can handle very well a downturn in economic activity. I hesitate a lot when I'm asked for to go on interviews, and CNBC and so forth, when we're in a situation like that, because I emphatically don't want to be a cheerleader on the downside when people are already concerned. The main interest that I have right now is in making sure that people who have investments and have different positions in stocks and so forth are in a situation where they can maintain their discipline through whatever happens.

Leggio: I guess one question that people might have is, the last time you warned so strongly to investors was in November 2007, and valuations were much more stretched than they are now. I guess, what would you say to someone who's really more valuation focused, why should that person be as concerned today as they were in November '07?

Hussman: Well, a couple of reasons. One is that, when people talk about valuations, they tend to be talking about forward earnings. In other words, analyst estimates produced by Wall Street, and the problem with those forward earnings estimates is that they are very frequently so dead wrong as to be irresponsible. I think, if you look at the stock market on the basis of normalized earnings, on the basis of the actual cash flows that companies have historically, and I can't emphasize enough, actually delivered over time, and metrics that measure those things, we are not undervalued here, we are actually significantly overvalued.

Again, at the point where the stock market right now in terms of the S&P is priced to deliver on our estimates about a 7% 10-year return. Certainly, better than we had about a month and a half ago, when we were looking at numbers that were closer to 6%, and starting to dip into the high 5s, and certainly better than 2000, where we actually had a negative 10-year total return expectation. But we're not in a market that is cheap here, and we are in a market where a lot of the enthusiasm that investors have priced into the market is really based on the assumption that this is a normal post-war recovery that will continue for several years and that will achieve profit margins that have historically been in the very upper ranges of experience.

The market's expectations by Wall Street analysts, for instance, implicitly imply profit margins that are among the highest levels in history, and I think that's a dangerous thing to build into one's valuation assumptions.