Reuters / Cheryl Ravelo-Gagalac
- John Hussman, the outspoken investor and former professor who has been predicting a stock market crash, calls out a big mistake he says investors are making as valuations continue to climb.
- He sees this dynamic specifically playing out in the tech sector, which has been largely responsible for market gains in recent months, leaving them that much more vulnerable.
In the stock market, the concept of valuation can mean different things, depending on the investor.
To novices, it's frequently used as a simple barometer of when an investment gets overextended. Conventional wisdom there suggests once valuation gets stretched too far, it might be time to sell.
But to seasoned experts like John Hussman - a former economics professor who is now the president of the Hussman Investment Trust - assessing valuation is more nuanced.
He subscribes to what he calls the Iron Law of Valuation, which says the higher the price investors pay for future cash flow, the lower their long-term investment returns will be. In other words, if you arrive late to the party, don't expect to get the full experience.
It's a relatively basic concept that informs Hussman's view that irrational investor behavior will eventually lead the market to its doom. Piggybacking off the Iron Law, he points out that as prices have surged, people still seem perfectly content chasing returns, as if they expect the rally to continue forever.
Ever the market skeptic, he says such an approach is a big mistake, and creating a dangerous situation.
"Market returns and economic growth have underlying drivers," Hussman wrote in a recent blog post. "At their core, extended periods of extraordinary growth and disappointing collapse reflect large moves in those drivers from one extreme to another. Extrapolation becomes a very bad idea once those extremes are reached."
Scary market precedents
In order to showcase the dangers of such extrapolation, Hussman looks at a how a measure of price-to-sales (P/S) has looked for the S&P 500 during the two recent stock-market eras.
From 1982 to 2000, when the equity benchmark was enjoying average annual total returns of 20%, the P/S ratio surged from 0.3 to an "offensively extreme" 2.2.
The opposite dynamic played out in the period from 2000 to 2009. During that time, the S&P 500 fell by half as P/S declined from 2.2 to less than 0.7, despite strong overall growth in both revenue and earnings.
Long story short, as P/S goes, so does the market. And then, when it gets to an extreme, it can abruptly change course, catching many investors off-guard.
With that in mind, consider the P/S situation as it stands right now. It's at a record high of 2.4, having climbed from less than 0.7 in 2009. Based on historical precedent, that's a serious danger zone for equities.
That fact informs the view currently held by Hussman, who also takes a shot at price-insensitive quantitative investors when providing his assessment.
"Extrapolating the market gains of these past several years, as if they are somehow a birthright of passive investing, is likely to have brutal consequences for investors," said Hussman.
The chart below provides a visual representation for why Hussman thinks these consequences could be manifested as a two-thirds decline for the S&P 500. The red line shows the half-cycle return for the index, relative to Treasury bill returns. The blue is an inverse representation of the vaunted P/S metric.
If the red line follows the blue one, as it has historically, Hussman says his forecast will come true.
Digging into tech
No discussion of highly-speculative valuations is complete without an assessment of the mega-cap tech firms that have driven so much of the market's recent performance. That means the so-called FAANG group, which consists of Facebook, Amazon, Apple, Netflix, and Google.
To Hussman, they provide a perfect case study of just how willing investors are to ignore the Iron Law.
"When companies are growing very quickly, investors tend to look backward, and as a result, they often apply very high rates of expected growth to already mature companies," he said. "When valuations are already elevated, this practice can be disastrous."
The tech sector did absorb a scare of sorts this past week, as Facebook's stock tumbled 19% - erasing a US stock-market record $120 billion of market value - after forecasting slowing growth. While it's far too early to say if this was an isolated incident or an industry-wide affliction, the outsized damage seen by Facebook should be a warning to its peers.
Hussman also points out that a revenue slowdown is already happening at Apple. He notes the company's sales growth rate, which has slowed to an average rate of less than 4% annually over the past three years.
"Investors should, but rarely do, anticipate the enormous growth deceleration that occurs once tiny companies in emerging industries become behemoths in mature industries," he said.
"You can't just look backward and extrapolate. In the coming years, investors should expect the revenue growth of the FAANG group to deteriorate toward a nominal growth rate of less than 10%, and gradually toward 4%."
Hussman's track record
This type of commentary shouldn't be surprised to anyone who follows Hussman. He's repeatedly made headlines by predicting a stock-market decline exceeding 60% and forecasting a full decade of negative equity returns. And as the stock market has continued its seemingly unstoppable grind higher, he's persisted with his calls, undeterred.
But before you dismiss Hussman as a wonky perma-bear, considering his track record, which he breaks down in his latest blog post. Here are the arguments he lays out:
- Predicted in March 2000 that tech stocks would plunge 83%, then the tech-heavy Nasdaq 100 index lost an "improbably precise" 83% during a period from 2000 to 2002
- Predicted in 2000 that the S&P 500 would likely see negative total returns over the following decade, which it did
- Predicted in April 2007 that the S&P 500 could lose 40%, then it lost 55% in the subsequent collapse between 2007 and 2009
So keep that in mind as you weigh your next stock-market decision. Hussman's doomsday scenario may not have transpired quite yet, but one would still be wise to heed his warnings.