Stock Valuations Continue to Rise to New Highs

This image of a margin-adjusted CAPE, provided by Hussman Funds, shows that stocks continue to reach new highs of excessive valuation.

Inflation Expectations and Stock Valuations

by Bill Hester, CFA, of Hussman Funds:

It is clear from February's inflation data that there was a broad increase in price levels last month, especially for goods used during the early stages of production. The Producer Price Index rose 5.6 percent from its level a year earlier, up from 3.6 percent in January. On a month-to-month basis, the PPI rose 1.6 percent, doubling its recent pace. That increase was partially fueled by higher food prices, which makes up about a fifth of the overall PPI. Commodity prices tracked within the PPI Index rose 8 percent from a year ago, up from 5.6 percent last month.

Because of the price trends in food and energy, and the likely longer-term consequences of quantitative easing, investors and households are beginning to expect higher rates of inflation in the future. Implied inflation levels derived from the difference between 10-year nominal and real yields in the US have increased by 90 basis points since August. These recent yield levels suggest an annual inflation rate of about 2.5 percent.

Households are also expecting higher rates of inflation. Prices will rise by 4.6 percent over the next year, up from 2.2 percent in September, according to a poll by the University of Michigan. Over the next 5 to 10 years, inflation is expected to be 3.2 percent a year, versus 2.7 percent in September.

Those numbers – especially the longer-term inflation expectations – are not particularly high by historical standards. Nor are they high compared with the historical rate of inflation - which on a year-over-year basis has averaged 3.7 percent since 1950. This has left the Fed unfazed. In Chairman Bernanke's recent testimony to Congress he suggested that any rise in price levels from commodity inflation would be “temporary and relatively modest.”

Another way to look at inflation expectations is to compare them with the trailing inflation rate over the most recent 12-month period. This is especially important for investors, because stock markets are sensitive to inflation rates rising quickly, even if the advance is from a low base (more on this below). Therefore, it's important to measure inflation and inflation expectations compared with recent trends in trailing inflation.

The graph below shows the difference in inflation expectations and the Cleveland Fed's median CPI rate. The Fed's median CPI tracks the "core" CPI well, but because it's not exposed to outliers it tends to be less volatile. The blue line in the graph below is based on year-ahead inflation expectations. The green line is based on inflation expectations over the next 5-10 years.

The graph shows that inflation expectations - relative to trailing inflation – have been generally well contained for 25 years. In the early 1980's, inflation expectations collapsed quickly, slightly outpacing the decline in trailing inflation (bond investors were more suspicious, as yields were much slower to decline during this period). But since the mid 1980's inflation expectations have generally been confined to about one percent above or below trailing measures of inflation.

Look at the recent spread. One-year expected inflation is now 3.6 percentage points above recent inflation. Longer-term inflation expectations are now 1.9 percentage points above recent inflation. Even if overall inflation expectations have not jumped to a level that concerns the Fed, it's clear that inflation expectations relative to trailing levels of inflation have broken out of their long-term channel.

It will be important to monitor this spread between inflation expectations and trailing inflation. If the spread stays constant then as the trailing inflation rate rises, inflation expectations will increase to levels where the central bank would take notice. Last month, New York Fed President Bill Dudley said, “If inflation expectations were to become unanchored because Federal Reserve policy makers failed to communicate clearly, this would be a self-inflicted wound that would make our pursuit of the dual mandate of full employment and price stability more difficult.”

PPI Trend Levels

The topic of inflation tends to be a tool used by both sides of the debate about stock market performance. It's argued that because corporations can pass on rising prices of raw goods to consumers, earnings will keep pace with inflation, so equities are a good hedge against inflation. It's also argued that because the 1970's was a terrible decade to own stocks, very high rates of inflation must be bad for equities. As in many discussions surrounding financial market topics, there is some truth in each of these arguments. But the full story tends not to lend itself to such broad generalizations. As John Hussman observed a few weeks ago, stocks can benefit from inflation once it is widely anticipated and well-reflected in valuations, but otherwise, stocks are not a very good inflation hedge in periods when inflation is rising.

Maybe one of the most underrated risks regarding inflation is the speed at which it is rising, even if that increase is off of a low base. It's not high levels of inflation that precede important stock market declines, but instead how rapidly inflation is rising relative to its recent trend. And when you mix an overvalued market with rapidly rising inflation, bad outcomes tend to follow.

We can use the Producer Price Index to highlight this characteristic. The graph below shows each occurrence where inflation in the PPI Index was above 3 percent, the most recent PPI value was at least 60 percent above its 18-month moving average, and the cyclically-adjusted P/E ratio was above 16. For clarity, I've only displayed the first occurrence in any 12-month period. This set of conditions highlights periods where valuations were high (and therefore risk premiums are low) and producer inflation was rising at a fast pace relative to its recent trend.

It's clear from the chart that periods following high P/E multiples and quickly rising rates of inflation haven't worked out well for investors, on average. The worst instances came in December of 1965, three months prior to a 23 percent decline, in February 1973, a few weeks into a decline which would take stock markets down by half, in September 1987, and in September 1999 and October 2007, just prior to last decade's two 50 percent-plus declines. The May 1989 instance was early, as the economy didn't enter into a recession until the summer of 1990. But the market was mostly unchanged during this period, and would eventually fall by 20 percent. The one instance that was followed by gains came in July of 2003.

It's important to note that I'm not suggesting this as an investment model in itself. For one, it lacks a re-entry signal. It also leaves out important measures of investor sentiment and internal market action. Because multiples were low and inflation measures were flattening out, there was no signal prior to the nearly 30 percent decline during the summer of 1982, which marked the end of a 17-year secular bear market. That said, for a metric that use a single economic statistic and valuation criteria, it has historically highlighted important oncoming risks.

Note that the warning signal above doesn't demand high levels of inflation – just 3 percent, to indicate that some amount of inflation is already built into the economy. The most recent PPI inflation rate was 5.6 percent. All but one of the occurrence represented by the arrows above (the exception was in 2008) were at the same level or below the recent PPI inflation rate. The signals in 1966, 1968, 1987, and 2000 were all registered with a PPI under 3.5 percent.

The set of characteristics also doesn't demand high levels of valuation. The graph below puts this into perspective. Above each of the arrows for the above criteria, I've noted the cyclically-adjusted P/E ratio (which smoothes real earnings out over the prior decade). The market has run into trouble with far lower multiples than current levels of valuation when early-stage inflation was rising quickly.

Of course, the stock-market bubble era of the late 1990's through 2007 stands out. Valuations were higher at the peak in 2000 and again in 2007 than current levels, before stock prices declined. And the multiple was roughly the same prior to the 1966 decline. But the multiple was just 18 prior to the collapses in 1973 and 1987. Removing the valuation filter doesn't change the above sample set materially, it just shifts signals around slightly. That's because high levels of inflation relative to recent trends have often occurred in mature economic expansions, accompanied by high valuations – like those in 1973, 2001, and 2007 - just prior to the recessions that followed those signals.

In many ways QE2 has made the recent economic recovery much more divergent than most. Some metrics of this recovery resemble the characteristics of economy late in an expansion – including measures of production activity and increases in producer price indexes – while some components still resemble the characteristics of early-stage recoveries – like the number of net new jobs being added to the economy. When the PMI Index has been above 60 (it's currently 61.4), the average unemployment rate has been 5.5 percent (it's currently 8.9 percent). Price indexes are similarly stretched. When the PMI Price Index has been above 80 (it's currently 82), the jobless rate has typically been 5.2 percent. So QE2 has produced a more "stagflationary" economic profile than is usually the case.

Higher prices are also increasing the pressures on households whose incomes continue to stagnate and who continue to struggle with debt loads. The imbalances within this recovery are likely going to represent the next obstacles to higher valuations – or maintaining current levels of elevated valuations – that investors confront. The divergences in the characteristics of this recovery will likely become even more visible as higher prices of raw goods work their way into measures of consumer inflation.

Consumer Inflation

The graph below applies nearly identical metrics to the slightly less volatile CPI Index. The arrows on this graph show where the year-over-year change in CPI was above 3%, the inflation level was 50 percent above its 18-month moving average, and the P/E ratio was above 16. Applying these criteria to changes in the CPI Index gives fewer signals – no signal was given prior to the 1969/1970 decline, the 1991 decline, nor prior to last year's correction. Still, tracking CPI momentum has proved valuable by signaling what we can justifiably call the Four Big Ones: 1973, 1987, 2000, and 2007.

This time in the graph, I've plotted the levels of the year-over-year change in the CPI at the time of each signal. In this case, these are more instructive than the signals themselves. Investors don't wait until inflation is rising at 15 percent a year to start aggressively selling overvalued equities. They don't wait for 10 percent or 7 percent inflation, either. The highest level of inflation within this group of signals was 5.5 percent, prior to the bear market of 1973-1974. All of the other signals that preceded declines coincided with rates of consumer inflation somewhere between 3.2 and 4.3 percent. It's the combination of high equity valuations and the acceleration in the rate of inflation - even if that increase is off of low levels - that has represented the most dangerous periods for risk taking.

In February, the CPI was up 2.1 percent from a year ago. This was up from an annual inflation rate of 1.6 percent in January. It's well within reason to expect the rate of consumer inflation to rise above 3 percent over the next few months. A continuation of the recent trend would put year-over-year inflation above 3 percent by May. Keep in mind that the CPI Index hit its low in June 2010. So the year-over-year calculation will get a natural boost as the index moves higher over the next few months. If the CPI climbs above 3 percent by June, it will also almost certainly be more than 50 percent above its 18-month moving average. The CAPE Ratio is currently 24.

The start of a contraction in valuation multiples has historically come long before high levels of inflation. Rather, it's inflation rising faster than its recent trend - sparking concerns of higher longer-term inflation - that increases risk aversion among investors. When these periods occur alongside high P/E ratios, the contraction in multiples has usually been substantial. Ben Bernanke recently told Congress that he is confident that the recent rise in the rate of inflation will be temporary, and that inflation expectations are unlikely to become unhinged. Stock investors must be able to share that belief and that forecast, because a change in longer-term inflation expectations – even from a low base – would increase stock market risks importantly.

Stocks Valuations Through the Roof

Hussman: Perspective on Recent Market Weakness

from John Hussman of Hussman Funds. I nominate John Hussman to be the next Fed chairman. That monthly chart speaks volumes about where we're at. Even devastating earthquake, tsunamis, Arab world unrest, and catapulting crude oil prices, can't dampen the bubblishness of Wall Street. 

Good analysis and perspective:

The market action of the past two weeks contrasts with the generally uncorrected advance of recent months. The chart below places this pullback in perspective, relative to the "big picture" for the S&P 500, showing monthly bars since 1996. I suppose it's possible for investors to characterize the recent decline as a "panic" if they press their noses directly against their monitors, but in that case, they really do have a short memory. The pullback has been negligible even relative to the action of the past several months, and is indiscernible in the big picture. As of Friday, the market remained in an overvalued, overbought, overbullish, rising-yields syndrome that has typically been cleared much more sharply than anything we saw last week.

We still expect to establish a moderate positive exposure to market fluctuations if we can clear some component of this syndrome, provided that market internals (breadth, leadership, sector uniformity, etc) don't also deteriorate substantially enough to signal a shift to risk aversion among investors. We've already seen meaningful breakdowns in international markets, both within and outside of Asia. Thus far, market internals in the U.S. have maintained intact, though still burdened with a negative syndrome of conditions over the short-to-intermediate term. Even with a more constructive position, we would still expect to maintain a strong line of put option protection in the event of abrupt weakness, but suffice it to say that we don't require a major change in valuation in order to be willing to accept greater market exposure - just enough to clear this syndome without strongly damaging market internals.

In order to clear this syndrome, last week's decline would have required either a meaningful retreat of investor bullishness, or a deeper price decline on the week. That said, the pullback did clear very short term overbought conditions, and we covered some short calls and lowered some put strikes as the market briefly challenged the 1250 level. This maintains a defensive line of index put options for the entire portfolio of Strategic Growth, but leaves us with short calls against only 60% of the portfolio. The change wasn't very observable on Thursday and Friday, because the sharp drop in implied volatilities (to a VIX of 23) created some short-term drag. But even here, any sustained upmove in the market should be far more comfortable than what we've experienced since QE2 triggered the recent speculative run.

It's important to recognize that various indicators used by investors often have implications contrary to what is commonly assumed. For example, the strong ISM Purchasing Managers Index reading above 60 is widely seen as a favorable indication for stocks, yet historically, readings above about 59 have been followed by negative average returns for the S&P 500 over the short- and intermediate-term, and flat returns over a 12-month horizon. Weaker PMI readings are actually preferable, so long as they don't occur within a syndrome of pre-recession signals (rising credit spreads, flattening yield curve, weak employment growth and tepid stock returns).

Meanwhile, a "This time is different" perspective may very well apply to the increasingly extreme policy moves that have been required to produce a surface layer of economic growth, but while this has affected short-term market dynamics to a surprising degree, it doesn't materially change the long-term stream of cash flows that stocks are likely to deliver. So positive short-term returns come at the cost of progressively thinner long-term return prospects.

Our investment orientation is emphatically long-term and full-cycle. Even so, short- and intermediate-term returns do matter, particularly those that have some hope of being retained. Even in richly valued markets, there are often conditions that have been associated with positive average return/risk profiles when you look across numerous subsets of historical data. Those favorable conditions reasonably warrant a moderate exposure to market fluctuations, and we would certainly prefer to observe and respond to those opportunities. Until we do observe them, however, we have aligned ourselves with the expected return/risk profile associated with the current set of market conditions. For now, that profile remains negative.

The events in Japan have had a tragic effect on individual lives, and they are undoubtedly in all of our prayers. With respect to the global economy, there will likely be supply disruptions, and reallocations of trade, but we would expect these to be mainly of a short-term nature. Given that the most strongly affected areas were not heavily urbanized or industrialized, the increased demand for raw materials is also unlikely to be enormous. Instead, it is likely to be modest and spread over a large number of years. Witness the slow pace of reconstruction in the wake of Katrina, and in other places that have been hit by natural disasters in the past. Invariably, such disasters result in rapid destruction but very slow and long-term reconstruction.

The larger economic problem is that this disruption is occurring when there are other economic pressures elsewhere, particularly in Europe. The U.S. has quite a bit of slack capacity, so the prospects for economic growth over a multi-year period seem reasonably good, but the frequency of weak patches is also likely to be higher in the next several years, and it is worth keeping in mind that much of the recovery we've observed - particularly in the credit markets - is a veneer over continuing credit issues.

Nobel economist Joseph Stiglitz tied the issues together nicely in an interview that appeared in Barron's over the weekend. Speaking about Japan, he observed "The sad thing is that they've never fully recovered from the bubble of 1989 bursting. In that sense it should remind the U.S. of what happens if you allow a bubble to get outsized. It's water under the bridge, but Bernanke and Greenspan have to bear some responsibility for that ideology that bubbles don't really exist, and they clearly do. When we went into this financial crisis, the administration said, 'We won't make the mistake of Japan and delay restructuring.' That's exactly what we did. It's mind-boggling that we haven't learned any of the lessons of Japan."

My only disagreement might be that any of this is actually "water under the bridge," because the same basic policies that produced the bubble are still very active. These policies have driven financial assets to rich valuations and low prospective returns, which compete sufficiently well with zero interest rates, but offer little for long-term investors. Meanwhile, the financial sector has a continuing overhang of delinquent and unforeclosed homes, which the FASB still allows banks to carry on their books at amortized cost. When the main source of "prosperity" is the policy-induced elevation of asset prices - rather than the allocation of savings into productive investment - it helps to remember that present gratification often equates to future unpleasantness.

When we look around the world, we see difficult social tensions, particularly in North Africa and the Middle East where the poor are dealing with enormous increases in the prices of basic commodities (and where the much of their budgets go for food and fuel), at the same time that others in the same societies are enjoying disproportionate wealth, particularly based on strong oil revenues. Certainly, inequality and oppressive leadership has existed in many of these countries for a long time. But we have to ask what has heightened these tensions to the tipping point at this particular time.

The Buddha taught that you can only understand something by looking deeply at its interconnectedness to other things, and to our own selves - nothing has a separate existence. "This is, because that is; this is not, because that is not." The problems and imbalances that have inflamed the world did not emerge from a vacuum. Rather, this is, because that is. It cannot possibly help that the Fed continues to pursue an aggressive policy that drives short-term interest rates to negative levels, which predictably encourages commodity hoarding around the globe, and the unintended consequences that result.

In any event, our present investment stance is not driven by a thesis regarding QE2, underlying credit issues, or even the sustainability of economic growth. It is driven by present, observable conditions on a wide variety of measures. On the basis of a large ensemble of historical time periods, valuation thresholds, and indicator sets, present conditions map into the expectation of negative total returns per unit of risk. Strategic Growth and Strategic International Equity remain well-hedged, though the composition of those hedges reflects the conditions we observe in the U.S. versus other countries (risk aversion is weaker in the U.S., which creates the potential for more speculation, particularly if we clear overbought or overbullish conditions).

Speaking of Valuations: Pricey Markets Mean Poor Returns

 

 

As discussed in previous posts, the benefit of a normalized P/E ratio (and a historical perspective) is that it gives us cues on whether the current price of the market is cheap or expensive and thus whether future returns will be high or low.

The S&P 500 Normalized P/E ratio as calculated by Robert Shiller stands at 23.3. Ed Easterling's work produces similarly elevated valuation levels. Not only is this well above the long-term average, but it is consistent with very disappointing long-term expected returns.

UPDATE: I was wisely encouraged to consider TOTAL returns, with dividends re-invested
But just how disappointing are returns likely to be? I spent a few hours on Friday afternoon geeking out in excel. I found that when the cyclically adjusted P/E ratio is between 22 and 24 (as it is now) the average annual real returns (after inflation) for the subsequent 10 years is -2.2%! And as usual, the average doesn't quite tell the whole story. In the 66 month ends since 1881 when the P/E was between 22 and 24 the distribution of subsequent returns looks like this:

The median total return is -3.1% real. It seems exceedingly likely to me that long-term returns for the stock market from here will be negative. I don't think most investors are prepared for these sort of outcomes over the next decade.

For those who care to see their returns nominally, the average is +1.2% annual returns and the distributions are as follows:

Several successful investors use the same concepts to drive actual estimates of future market returns.

John Hussman, PhD uses this methodology to help drive decision making with his mutual funds. His recent work produces estimated NOMINAL returns over the next 10 years of 3.1% annualized which may be close to zero real returns depending on inflation.

Using a 5 year time frame, the "probable outcomes" are even worse, with 0% projected nominal returns.

GMO does similar work with additional emphasis on where profit margins are relative to normal (and likely to revert towards) and does so across various asset classes and publishes their results monthly. These are also nominal returns and are certainly not high enough to warrant a buy and hold or long-only approach especially when one considers that this is just a range of estimates and the downside to low estimates is equally as likely as the upside.

The fact is that what you pay matters and expensive markets today mean low or even negative prospective returns going forward. The value restoration project, which began with the peak of the stock market in 2000, is ongoing despite a 2 year cyclical rebound on the heels of unprecedented stimulus.

Read the Sitka Pacific Annual Review for more on the multitude of challenges facing investors.

Of course, in the short term the market can get more expensive. Those calling for negative returns in 1997 or 1998 based on this sort of methodology were certainly frustrated over the course of the next 2 years as the market when from merely expensive to insanely bubblicious. My colleague Mish had a nice post looking at the returns over various time periods when you start with expensive markets. In the first year the returns ranged from -30% to +33%.
UPDATE: Hussman cites Mish's work in his latest Weekly Commentary.

I believe this are nominal returns which means that all of those single digit 10 year returns starting in the late 60s were certainly negative after the effects of inflation. 

Secular bear markets ALWAYS have powerful rallies which has nothing to do with the fact that bear markets NEVER end until the market is "not just interesting, but rather commandingly, and compellingly cheap." I don't portend to have a crystal ball, but it seems to me that our powerful bear market rally is getting rather long in the tooth.

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John Hussman: Anatomy of a Bubble

Great analysis by John Hussman. No one is better!

Over the past decade, investors have seen near-parabolic advances in a variety of assets, followed by crashes. These have included dot-com stocks (which peaked and crashed well before the general market peak in 2000), technology stocks, housing, commodities, and stocks in a variety of emerging markets. These experiences have made investors somewhat more attuned to the destructive potential for speculative bubbles in various assets, but has also created something of a "casino economy" where a great deal of resources are directed in hopes of participating in these bubbles.

What exactly is a "bubble?" Informally, we can think of a bubble as an advance in an asset's price to levels that are "detached from fundamentals" - essentially, the primary motive for investing ceases to be the expectation of future cash flows or consumption, and instead centers on the expectation of further increases in price. From this perspective, a bubble emerges at the point where a continual increase in the ratio of prices to fundamentals is required in order for investors to achieve satisfactory returns.

Formally, a bubble can be defined as a "non-fundamental" component of price which grows exponentially. Think about stocks. Let "k" be the long-term return that investors expect stocks to achieve. If these expectations are correct, then next year's price Pt+1 will just be (1+k) times today's price Pt, minus whatever dividend Dt will be paid. The next year's price is determined the same way. If you write this out and solve the difference equation, you'll get a solution that looks like this: Pt = Vt + Bt, where Vt is just the discounted value of expected future dividends, and Bt is an arbitrary constant. It can be anything, so long as it obeys Bt+1 = (1+k)Bt.

Mathematically, Bt is a "bubble component" of prices. If that component Bt is not zero, the price will gradually "explode" away from any relationship with fundamentals. Moreover, the present discounted value of the future price will not tend toward zero no matter how far into the future you look. Ultimately, this sort of price path is ruled out by the fact that the value of stocks cannot grow infinitely larger than the economy, so bubbles ultimately crash. But over the short-run, there is little to prevent investors from putting a little bit of "B" into prices from time to time. This becomes pathological when the sustained price gains expected by investors diverge significantly from the growth rate of the overall economy.

In short, a bubble is an advance in prices that "substitutes" for fundamentals, in the sense that the realized return on the investment continues to be positive even after the asset is no longer priced to achieve satisfactory returns on the basis of expected future cash flows (or in the case of housing and commodities, future consumption value or other services).

The effect of valuation levels and valuation changes on S&P 500 total returns

When valuations are reasonable, investors can expect satisfactory long-term returns simply on the basis of the stream of cash flows they receive over time. But once valuations are elevated, investors become increasingly reliant on pure increases in prices and valuations in order to achieve satisfactory returns. This is easily seen in historical data for the S&P 500.

The chart below is based on post-war U.S. data, and illustrates the interaction between valuation levels and valuation changes in producing long-term total returns for the S&P 500, and expands on some of Mike Shedlock's recent observations on valuations and prospective returns. As I've frequently noted, Depression-era data is far more hostile than post-war data, as is data surrounding other historical and international credit crises, so investors would have needed more stringent valuation criteria in order to accept market risk during these periods. Still, post-war data is sufficient to convey some important ideas.

The first two columns below reflect the Shiller P/E (also known as the "cyclically adjusted" price/earnings ratio), and the frequency of various P/E ranges in historical data. The next two columns show the average annual total return of the S&P 500 Index, based on whether the Shiller P/E rose to a higher level during the 10- or 5-year horizon, or whether it fell to a lower level by the end of that horizon. The next column is the percentage of observations where the P/E was higher at the end of the horizon, and the last column is the weighted average return for each level of Shiller P/Es.

Notice that regardless of whether P/E ratios rose or fell during these investment periods, subsequent returns were substantially higher from low valuations than from high ones. Of course, subsequent returns were higher for horizons where the P/E increased than for those where the P/E fell. It is also important, though not surprising, that low initial valuations were associated with a far higher probability of rising valuations in the future. With low valuations, investors have enjoyed the prospect for high expected returns even if valuations contracted further, and also faced a high probability that a future increase in P/E multiples would add further to their returns. In contrast, high valuations have been associated with poor average returns, and a low probability of further increases in valuation multiples.

Since data is available for 5-year returns through 2006, but only through 2001 for 10-year returns, the two tables cover slightly different horizons since 1940. Notably, the frequency of Shiller P/Es greater than 24 is 15.3% in 5-year data but only 9.3% in 10-year data. This is because extreme valuations have been the norm in recent years (where the P/E has exceeded 24 over half the time, interrupted only briefly by the recent plunge and rebound).

Presently, the Shiller P/E stands at 24. Be careful how you interpret the data in the table for Shiller P/E's above 24, since these levels were almost never observed in data prior to the late-1990's market bubble. You can see the odd effect of the bubble on the P/E categories above 20. The recent tendency for high valuations to move even higher over the short-term, coupled with the rapid recovery of much of the 2008-2009 loss, creates a "hump" in the 5-year profile - average returns first decline as valuations increase, and then actually improve for the 20-24 bracket. This is an artifact of recent years, and appears neither in pre-1995 data nor in 10-year return data.

Indeed, outside of the bubble period since the late 1990's, the only historical instance of Shiller P/Es materially above 24 was between August and early-October of 1929. The closest we got to 24 in post-war data was in mid-1965. While prices went on to achieve moderately higher levels (lagging earnings growth, so that the Shiller multiple fell), the mid-1965 valuation peak is widely viewed as the starting point for a 17-year "secular" bear market during which the S&P 500 achieved total returns of less than 5% annually through 1982, despite severe inflation. That's a good reminder that stocks are not a very good inflation hedge during periods when inflation is rising, particularly when stock valuations are already elevated and are priced to achieve poor returns. Stocks only "benefit" from inflation during hyperinflations and during sustained and anticipated inflations. In other cases, the eventual adjustments in economic activity and valuations overwhelm the "beneficial" effect of inflation on earnings.

The implication of this data for long-term returns is clear. With the Shiller P/E presently at 24, we observe about the same implications for 10-year S&P 500 total returns as we obtain from our broader valuation methods (expected total returns averaging about 3.5% annually). Still, the actual course of total returns will depend on whether valuations become even more extended over the next 5-10 years, or if they contract instead. Even if one includes data from the late-1990's bubble, the probability of rising P/E multiples from these levels is less than 1-in-5.

Still, if one wishes to bet on a bubble, there is no reason set in stone that the market cannot achieve further gains. The question investors should ask, however, is whether confident prospects for a radiant economic future are likely to capture the imaginations of investors to anywhere near the extent that we observed during the late 1990's. The answer matters, because if we exclude the bubble period, the historical probability of rising P/E multiples from present levels effectively drops to zero - similar valuations were always followed by a contraction in multiples.

Long-term versus near-term

I want to emphasize that the arguments above relate to 5-year and 10-year horizons, and not how the market may perform over the next several months or quarters. Over shorter periods of time, the strength and uniformity of market internals conveys important information about the willingness of investors to accept risk. Even if we observe rich valuations, there can be some justification for accepting market risk during periods when market internals are uniformly strong, provided that the environment is not also characterized by a syndrome of overbought, overbullish and rising-interest rate conditions. Accordingly, if we can clear at least one component of that syndrome (most likely the overbought or overbullish aspect) without also provoking a broader deterioration in market internals, we'll have a reasonable window in which to accept a moderate exposure to market fluctuations. A correction to the lower-1100's on the S&P 500, without a material breakdown in broader market internals, would likely open that window.

Here and now, market conditions imply a negative average return/risk profile for stocks, but clearing some component of that syndrome (again, barring a broader breakdown in market internals) should shift the expected return profile to a modestly favorable average, allowing us to reduce the extent of our hedges. Of course, we're likely to retain a "line" of defense with index put options, to protect against any abrupt further declines or broad deterioration in market internals. But it's important to emphasize that despite our dour view of long-term return prospects, those views don't necessarily translate into an avoidance of moderate exposure to market fluctuations over the short- and intermediate-term. We're very mindful of risk here, but shareholders can also expect us to accept moderate, periodic exposure to market fluctuations more frequently, on the basis of the expanded set of Market Climates we introduced last year.

For now, we're defensive and tightly hedged (though we've reduced the number of our short call options in recent weeks in response to market weakness). That tight defensiveness may only persist for another week, possibly several weeks, but probably not months unless we observe a material breakdown in market internals. We'll take our evidence as it comes. In any event, our longer-term view of market prospects is quite restrained, and we remain concerned about latent economic risks, so even if we have constructive opportunities over the intermediate term, we expect to maintain a line of defense against more serious downside risks.

Classic bubbles - parabolic advances and log-periodic fluctuations

From our perspective, there is at least a small "bubble" component at play when markets advance over the short run, despite being priced to achieve poor returns in the long-run. In effect, investors in these markets are taking on speculative risk, in the expectation that other investors will be willing to pay even higher prices. Whatever one wishes to say about the rationality of investors during these periods, the historical evidence is that certain features of market action (particularly broad uniformity of market internals) is a useful metric of investors' willingness to speculate. As I've frequently noted, neither market action, nor trend-following measures, nor an easy Fed has been sufficient once the overvaluation is coupled with overbought, overbullish, rising-interest rate conditions. But even during post-credit crisis periods, some combinations of market conditions have warranted at least a moderate speculative exposure to market fluctuations despite rich valuations.

In the stock market, I believe that there is indeed a "bubble" component in current prices, but it is not nearly as large as we observed in the approach to the 2000 peak, nor as extreme as we observed on the approach to the 2007 peak. My hope is that investors have learned something. That's not entirely clear, but we'll be as flexible as we can while also being mindful of the risks.

While my view is that bubble components can come and go in the markets, they sometimes become so large and well-defined that they take on a very distinct profile. Such bubbles included the advance to the 2000 stock market peak, the housing bubble, the advance in oil prices to their peak in 2008, the advance in the Nikkei in the late 1980's, and other clearly parabolic advances.

On that note, it's clear to me that we're seeing classic bubbles in a variety of commodities. It is very unlikely that this is simply due to global demand growth. Even with an exhaustible resource, it is a well-known economic result (Hotelling's rule) that the optimal extraction rule is one where the price rises at a rate not much different from the interest rate. What we've seen lately is commodity hoarding, predictably resulting from negative real interest rates provoked by the Fed's policy of quantitative easing.

Fortunately for the world's poor, the speculative dynamic that has created a massive surge in commodity prices appears very close to running its course, as we see very similar "microdynamics" in agricultural commodities as we saw with oil in 2008. That's not to say that we have a good idea of precisely how high prices will move over the short term. The blowoff phase of a bubble tends to be steep, but so short-lived that it affords little opportunity to exit. As prices advance in an uncorrected parabola, the one-sided nature of the speculation typically gives way to a frantic effort of speculators to exit simultaneously. Crashes are always a reflection of illiquidity in two-sided trading - the inability of sellers to find eager buyers at nearby prices.

As physicist Didier Sornette has observed, major parabolic bubbles also tend to include shorter-term fluctuations that are increasingly "chaotic" - specifically, there is a tendency for price dynamics to include a "log-periodic" component (which essentially looks like a cosine wave fluctuating at increasing frequency), so that corrections become shallower and more frequent within the parabolic trend. Eventually, these periods culminate in what Sornette calls a "finite-time singularity," which is about the point where the market crashes.

In my view, it's somewhat ambitious to use these self-similar fluctuations as the basis to time the end of a bubble, but it's clear that weakly corrected parabolic advances do tend to be unsustainable, and often produce deep and abrupt losses. As I wrote in July 2008 just as oil was spiking to $150 a barrel and headed toward $40 (see The Outlook for Inflation and the Likelihood of $60 Oil ), "When you have to fit a sixth-order polynomial to capture price history because exponential growth is too conservative, you're probably close to a peak."

On the subject of commodities, it's a natural question whether gold falls into the same category as agricultural commodities. After all, gold and other hard assets have an important role as an alternative to money to store value, and it appears clear that the world is monetizing in a way that is unlikely to be fully reversed even if policy makers wish to do so down the road.

In my view, it's not clear that gold is in a bubble here, but it will be important to watch for the earmarks of a classic bubble. Below, I've plotted the price of gold against a "canonical" log-periodic bubble. Already, we're seeing some behavior that is characteristic of a bubble-type advance. A Sornette-type analysis generates a finite-time singularity as early as April, but there are other fits that are consistent with a more sustained advance. If we observe a virtually uncorrected advance toward about 1500 in the next several weeks, the steep and uncorrected advance would imply an increasing hazard probability.

Again, for my part, I think it's a bit ambitious to use log-periodic functions and other purely mathematical tools to identify bubbles and gauge crash hazards. We prefer more fundamental approaches. While I don't view gold stocks as overvalued relative to the metal (which gives us some margin of safety in the gold shares we own in Strategic Total Return), we have to view the rate and character of the advance in gold with some suspicion. If gold continues a parabolic advance toward 1500, the risk of a very sharp decline in precious metals would increase substantially, in my view. Classic bubbles tend to have a "signature" - parabolic advances with shallow and increasingly frequent corrections. Eventually, you begin to see price spikes at one-day, one-hour and even ten-minute intervals. That's a danger sign to monitor. Remember, if emerging markets stocks have taught investors one thing, it's that it's very possible for a long-term thesis to remain intact and yet have prices suffer significant declines over the intermediate-term.

Market Climate

As of last week, the Market Climate for stocks remained characterized by an overvalued, overbought, overbullish, rising-interest rate syndrome that has historically been associated with negative returns per unit of risk, on average. Both the Strategic Growth Fund and the Strategic International Equity Fund remain well hedged, though this will change in response to any clearing of this syndrome that does not also produce a significant breakdown in market internals.

In the Strategic Total Return Fund, yield pressures improved on a number of measures last week, and we responded by modestly increasing the duration of the Fund to about 3.5 years (meaning that a 100 basis point change in interest rates would affect the Fund by about 3.5% on the basis of bond price fluctuations). The Fund continues to hold about 8% of assets in precious metals shares, and we continue to view those shares as reasonably priced in relation to the metal itself. That said, the near-parabolic rise in gold prices is of some concern, as noted above, so we are comfortable with a modest but not aggressive exposure to this asset class.

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