Risk Management is Generous
John P. Hussman, Ph.D.
All rights reserved and actively enforced.
With the S&P 500 just over 1200, the price/peak earnings multiple on the index has returned to 21. Aside from the 2000 bubble peak, this multiple exceeds the valuation seen at any historical market peak including 1929, 1972 and 1987. Meanwhile, junk bond yields have been compressed to the point where the bond market is pricing in negligible probability of corporate defaults in the years ahead. Corporate BBB yields are just a half percent over AAA yields, while spreads on pure junk are only about 2% over comparable Treasuries. This will end badly.
After several years of minuscule Treasury bill yields and with the S&P 500 still below its level of 6 years ago, investors are frantic for yield and return - a context which makes even unimportant performance differentials seem devastating. We've seen this appetite for risk before, at the 2000 peak, and at numerous market extremes of the past. Of course, there is no assurance the market is at the peak of this advance, or that valuations will normalize quickly ? certainly nothing that would prove useful as a short-term forecast. But risk management is generous - it is very tolerant of positions established somewhat early. Speculation, on the other hand, is extraordinarily unforgiving of positions taken off somewhat late.
Once again, investors seem to have lost their sense of simple algebra. It helps to remember that corporate earnings, despite extreme cyclical variability, are actually very well-behaved over the long-term. Whether one looks at the past 10, 20, 50 or 100 years, S&P 500 earnings have remained well contained in a 6% growth channel connecting earnings peaks across market cycles. Yes, earnings growth can be very rapid from trough to peak, with growth rates often exceeding 20% and 30% annually. But peak-to-peak variation is quite small. The growth rate of S&P 500 earnings was 6% from peak-to-peak even in the roaring 90's, productivity boom, new economy and all.
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