Investing Advice: How to Measure Bubbles

Posted On February 2, 2018 11:39 am

With Friday’s stock market decline snapping the record 404 trading sessions without 3% pullback crypto-assets are imploding all over the place. Today’s investing advice comes from John Hussman, whose monthly newsletter titled Measuring the Bubble is both timely and insightful for putting things in perspective.

Last week, the U.S. equity market climbed to the steepest valuation level in history, based on the valuation measures most highly correlated with actual subsequent S&P 500 10-12 year total returns, across a century of market cycles. These measures include the S&P 500 price/revenue ratio, the Margin-Adjusted CAPE (our more reliable variant of Robert Shiller’s cyclically-adjusted P/E), and MarketCap/GVA – the ratio of non-financial market capitalization to corporate gross value-added, including estimated foreign revenues – which is easily the most reliable valuation measure we’ve ever created or tested, among scores of alternatives.

A few charts will bring the valuation picture up-to-date. The first chart below shows the ratio of MarketCap/GVA, which now stands beyond even the 2000 market extreme.

Take MarketCap/GVA, put it on an inverted log scale (left) and you get the blue line below. The red line (right scale) is the average annual nominal total return of the S&P 500 over the subsequent12-year period. The correlation between the two is 93%. From present levels of valuation, we fully expect the S&P 500 to lose value, on a total return basis, over the coming 12-year horizon.

 Related: Is the Market Slowing? Here’s What You Need to Know. 

That’s not a worst-case scenario or an outcome that depends on unusual economic outcomes. It’s actually the standard, run-of-the-mill expectation given current valuation extremes, and it assumes substantial expansion in the U.S. economy over this horizon.

As a side-note, Shiller’s version will retreat by about 10-15% as depressed earnings from 2008-2010 gradually drop out of the 10-year window. Of course, given that Shiller’s raw CAPE is also much less reliable than our margin-adjusted variant, a decline in the Shiller CAPE, driven by a statistical artifact of its own construction, will not make stocks any less hypervalued. Because our Margin-Adjusted CAPE already adjusts for cyclical variations in the embedded profit margin, it does not suffer from similar “dropoff” artifacts when extremely elevated or depressed earnings fall out of the 10-year average.

One might object that the best-performing valuation measures mute the effect of variations in corporate profit margins to one extent or another. These measures would arguably be less extreme if elevated profit margins were given full credit. But that, emphatically, is the point. Stocks are not a claim to next year’s earnings, but to a very long-term stream of cash flows that will be delivered into the hands of investors over decades and decades. While corporate earnings are necessary to generate deliverable cash to shareholders, comparing prices to earnings is actually quite a poor way to estimate future investment returns. The reason is simple – most of the variation in earnings, particularly at the index level, is uninformative. Corporate earnings are more variable, historically, than stock prices themselves.

Critics of value-conscious investing have argued that even the most reliable valuation measures have been extreme for years now, and can therefore be disregarded, since the market has continued to advance. Hold on Scooter. It’s important to distinguish between the level of valuations, which has indeed become breathtakingly extreme in recent years, and the mapping between valuations and longer-term market returns (which we observe as a correspondence, where rich valuations are followed by poor returns and depressed valuations are followed by elevated returns). That mapping has remained intact, even in recent market cycles.

Continue reading here.

 Related: This Strategy is Better Than a Covered Call. Learn More Here. 


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Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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