Dissecting The Shiller P-E Conundrum

Longtime readers of Retirement Watch are familiar with Hussman Strategic Growth and its fall from grace. The fund had a great record prior to the 2008 financial crisis. Since the recovery began in 2009, the fund’s continued to hedge its portfolio, selling short stock index futures as stock indexes rose to record levels. The fund’s experience is not unique. Most quantitative and model-oriented funds with which I’m familiar have done poorly since the market bottom. I think that’s because they’ve relied on historical data and relationships that aren’t relevant in a period when the Fed is manipulating markets in a uniquely aggressive and persistent way.

Here’s a long explanation from Philosophical Economics blog. As I said, it’s a long post. It begins by dissecting the Ireland stock index to explain why it might not be a good idea to rely on historic data of the index to make decisions today. It then applies the same thinking to the S&P 500, with the conclusion that the Shiller P-E method can’t be used to make decisions in the post-crisis environment. There have been too many distortions.

Looking out over the long-term, it’s going to be very difficult for US investors to receive the “normal” 10% nominal annual equity returns that they have received historically.  Literally everything will have to go right.  Profit margins and returns on equity will have to stay elevated, contrary to the tendency of mean-reversion.  Multiples will also have to stay elevated, which means that interest rates will have to stay low.  But low interest rates are a consequence of weak economic growth and weak inflation.  How are companies going to consistently produce strong earnings per share (EPS) growth–the kind that would be needed to underpin 10% total returns for shareholders over the long-term–in an environment of weak economic growth and weak inflation?

Up to now in the current recovery, and really over the last 10 years, profit margin expansion and share buybacks have been the primary drivers of EPS growth for U.S. equities.  They are the reasons that strong EPS growth has been possible amid the persistent softness in economic growth and inflation (softness that has depressed the corporate top-line, but that has also provoked zero interest rates and an elevated P/E multiple).  Can profit margin expansion and share buybacks continue to be robust drivers of EPS growth, indefinitely, even as shares become more and more expensive for corporations to buy back, and as the income imbalances between capital and labor, the rich and everyone else, get closer and closer to the limits of economic and societal stability?  There are good reasons to think not.