John Hussman: Really Mean Reversion

May 13, 2014

by Robert Huebscher
In his most recent commentary, GMOs Jeremy Grantham said value investors
are destined to endure pain in a market bubble, especially in its latter stages, as
clients scorn them for missed opportunities. John Hussman is surely one such
investor indeed, Granthams commentary drew extensively on Hussmans
research. In a recent talk, Hussman explained why he, Grantham and other long-
term value-driven investors should be worried, even if equity markets perform well
in the short run.
Investors who hope to capture the last throes of a bull market dont realize how
quickly they will lose that on the way down, Hussman said.
Reversion to the mean will cause equity prices to fall countless observers have used metrics such
as the Shiller cyclically adjusted price-to-earnings ratio (CAPE) or Tobins Q ratio to explain this. But
Hussman went beyond that, providing a model that improves on conventional ways of predicting
market prices. He offered some predictions as to when the correction will occur.
Hussman spoke on May 2 at the second annual Wine Country Conference in Sonoma, sponsored
by Sitka Pacific Capital Management. This event has turned into one of the best opportunities to
engage with top-tier speakers in an intimate setting and to enjoy one of the best locations of any
conference youre likely to attend. All proceeds from this years event were donated to the Autism
Society of America, and I encourage readers to consider this worthwhile cause.
A copy of Hussmans presentation is available here.
Lets look at Hussmans explanation of how reversion to the mean operates and what prospective
equity-returns investors are likely to obtain over various time frames.
The dynamics behind mean reversion
Hussman offered a detailed explanation of the mathematics behind mean reversion but said one only
needs to answer a simple question to determine whether a variable such as equity prices is
mean reverting. Lets assume there is another fundamental variable (e.g., the market-capitalization-
to-GDP ratio) that is representative of the mean. Are future changes in one variable (equity prices)
inversely correlated with the current level of the fundamental variable (market-cap-to-GDP)?
In the case of equity prices, a high level of market-capitalization-to-GDP ratio is correlated with poor
subsequent stock-market returns, and vice versa. That assures that equity prices and stock-market
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returns mean-revert.
Hussman provided the historical examples to validate this assertion data which will be very familiar
to readers of his weekly market commentaries. Low market-capitalization-to-GDP ratios in the 1950s
predicted high returns over the subsequent 30 years, and high ratios in 2000 predicted the poor
returns equity investors suffered in the decade following the dot-com boom.
Market-capitalization-to-GDP is but one example of variables that can be used to test mean reversion
in stock prices. Whether you use profit margins, corporate taxes, corporate earnings-over-revenues
or a similar metric, Hussman said, you get the same result. Mean reversion hasnt broken.
He provided one interesting piece of analysis that I hadnt seen before. It turns out that, by
combining two variables, one can use mean reversion to make more accurate predictions of equity
prices than one could make with a single variable.
Earnings alone are fairly lousy at predicting stock returns over 10-year time horizons, Hussman
said, but if you combine them with profit margins, accuracy improves greatly. This is illustrated in the
three-dimensional graph from Hussmans presentation:
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If you were to look at this graph from either the x-axis (profit margins) or the y-axis (price-to-earnings
ratios), the points would be scattered and the correlation to the vertical z-axis (subsequent 10-year
S&P 500 returns) would be low. But when both the x- and y-axis data are viewed together in three
dimensions, the fit is very tight.
What does this mean, as a practical matter? Hussman said that the Shiller CAPE isnt a really great
valuation measure by itself, but if you take into account the implied profit margin, it becomes an
extraordinarily good measure. Unadjusted, the Shiller CAPE is now at 25, which is high, but not
extraordinarily so. But if you adjust that for the embedded level of profit margins, Hussman said, the
value is closer to 30.
Youre actually looking at a Shiller CAPE right now thats very high, and this is not a pretty level of
prospective long-term returns, he said.
Hussman was asked whether todays valuations at an unadjusted Shiller CAPE ratio of 25 could
be a new normal, reflecting profit margins and earnings permanently higher than have historically
been the case. That paradigm could be true, Hussman said, but only if you also believed that the
new normal long-term stock returns were 2% or 3% annually, instead of their nearly 10% historical
values.
For people who actually want to make that case, I have no argument against the math, he said. I
do have a question whether investors are fully aware that theyve priced securities, especially
equities, to return only 2% or 3% annually over the next decade.
Hussman also dismissed the argument that even though profit margins might decline over the next
couple of the years, stocks prices will remain elevated because they are a claim against cash flows
long into the future. According to Hussman, stocks have an effective duration of approximately 50,
so even a small drop in margins and earnings will trigger a large drop in prices.
How soon will equity prices revert?
Hussmans logic is eminently persuasive and consistent with the sentiment of all but the perma-
bull market observers. But the problem is that he and many others have been sounding the high-
valuation alarm for several years, while equity prices have climbed progressively higher.
Hussmans model shows that two-year returns on the S&P 500 will be approximately -20%, and if
full mean-reversion were to occur, stocks would lose half their value.
But Hussman doesnt expect that to occur.
Theres too much variation in two-year returns, he said. Valuations are not a timing tool. If youre a
value investor, youve got to be prepared to take heat for a long time, because mean reversion does
not happen overnight.
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When does Hussman predict mean reversion will occur?
One clue to the answer comes from the Kalecki equation, which I wrote about previously.
Essentially, that equation says deficits and surpluses in the private and public sectors must equal
one another. One of the reasons profits have been high, as have public-sector surpluses, is that the
private sector the government had been running large deficits.
But the federal deficit has been shrinking for about a year. I asked Hussman why this hasnt yet
translated to lower corporate profits.
That erosion will come, he said, but it may take a few years.
The reason gets into technical details. To use the Kalecki equation on U.S. data, you must also
consider investment, foreign savings and the net impact on our current account. There is a lag
effect. Based on historical data, it takes about six quarters before changes in the public sector show
up in the private sector. Hussman said that hes more worried about those changes showing up in
2015 than he is for the next quarter or so.
The other clue comes from Hussmans model and how well it predicts returns over various time
horizons.
Its predictability improves over longer time horizons. The fit is much closer looking out seven or more
years. By the time you get to 15 years, prospective returns on stocks are approximately 4.4%.
But that doesnt mean you shouldnt buy stocks for the next 15 years, Hussman said. A decline in
prices over the next couple of months or years could dramatically change things.
When you go out 20 years, the prospective return improves to 5.5%. Whats going on is that, as you
lengthen the time horizon, the expected range of error narrows. There is also an embedded
assumption of 6.3% nominal GDP growth, which lifts returns over longer time horizons. But
Hussman said there is also noise in the 20-year data (he called it off-phase behavior), which
makes those forecasts less reliable.
Hussmans advice
Investors are not doomed to long-term sentence of dismal returns, according to Hussman, nor
should they exit the equity markets. This is basically advice to be cautious at these levels, because
history is not on the side of people who think that theyre going to get strong investment returns from
here, Hussman said.
It wont take a dramatic fall in equity prices for Hussman to recommend a more aggressive equity
allocation. He said hed like to see at least reasonable valuations and an improvement in market
action following that decline. In regard to the latter point, he said he would look for a uniformity of
trends across securities.
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My strongest advice is to understand the structure of perspective returns so you have some sense
of how valuations and perspective returns go hand-in-hand, Hussman said. Have some of those
calculations and tools to guide your risk aversion and risk tolerance, based partly on valuations.
As a final warning, Hussman quoted Benjamin Graham, who wrote in Securities Analysis,
Observation over many years has taught us that the chief losses to investors come from the
purchase of low-quality securities at times of good business conditions.
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