For Professional Investors and Advisers Only
May 2017
Great Expectations – what’s
priced into the US stock market?
RWC Equity Income
Investor letter Q2 2017
The US equity market
continues its rise,
but what is priced in?
In this edition of our quarterly
letter Ian Lance discusses which
valuation metrics are the most
reliable indicators of future equity
returns and looks at what that
implies for US equities.
He also questions whether low
interest rates make equities
‘cheap’ as many commentators
seem to believe.
Portfolio Managers
Ian Lance, Nick Purves and John Teahan have
managed funds together for over 10 years. Their
loyalty and experience is leading within the industry
and has awarded them a number of accolades.
Ian, Nick and John joined RWC Partners in 2010 to
establish the Equity Income team and now manage
over £3.5 billion for their clients.
The team’s approach fully integrates conviction led,
value-based stock selection with a distinctive and
technical approach to stablising assets, with the aim
of delivering investment solutions that both grow
investors’ assets and protect the purchasing power
of capital and income.
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3
Great Expectations – what’s priced into
the US stock market?
The US equity market has been rising almost
continually for eight years and now stands more than
50% above both the 2000 and 2008 peaks.
Despite this, it is not unusual to hear commentators
describe US equities as looking ‘reasonable value’1
although as conventional valuation measures climb
off the top of charts, the optimists are increasingly
being driven to making the comparison between the
valuation of equities and bonds.
than 2000, median valuations are similar or higher
than the levels they reached at the dot com peak.
1. Median price to sales ratio
FIGURE 2:
US: PRICE-TO-SALES, 1974 – 2017
2.5
2.0
This note will start by considering the most reliable
valuation metrics of the US equity market to show that
they look anything but reasonable before questioning
the validity of the idea that low interest rates make
equities cheap.
1.5
1.0
0.5
FIGURE 1:
S&P 500 INDEX LEVEL, 1986 – 2017
2000
Source: Sanford Bernstein Quantitative Research, 1974 – 2017
1500
2. Median price to book ratio
1000
FIGURE 3:
US: PRICE-TO-BOOK, 1974 – 2017
500
2016
2014
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1974
1976
0.0
2500
4.0
3.5
2016
2014
2012
2010
2008
2006
2004
Source: Bloomberg, 1986 – 2017
3.0
2.5
2.0
1.5
1.0
0.5
2016
2014
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
0.0
1976
A neutral observer of US stock market valuations
would struggle to make the case that equities are
cheap based on any of Figures 2 - 4. These charts are
all median valuations; it’s worth remembering that the
equity market in 2000 was defined by a number of very
large and staggeringly expensive stocks with a long
tail of stocks that were actually reasonably valued.
Although cap weighted valuations today are still lower
1974
2002
2000
1998
1996
1994
1992
1990
1988
1986
0
Source: Sanford Bernstein Quantitative Research, 1974 – 2017
1 For example ‘Stocks aren’t overvalued – so keep buying’ by Ken Fisher Financial Times 27 March 2017
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3. Median price to trailing earnings ratio
4. The Shiller cyclically adjusted price
earnings ratio
FIGURE 4:
US: PRICE-TO-TRAILING EARNINGS, 1974 – 2017
A valid criticism of Figure 4, which looks at priceto-trailing (12 month) earnings, would be that US
corporate profit margins are close to all-time highs
and this would tend to depress the valuation multiple
and make equities look cheaper than they really are.
For this reason, many investors choose to consider
the Shiller cyclically adjusted price earnings ratio
which takes an average of the last ten years earnings
(adjusted for inflation) in an effort to normalise for
varying levels of profitability across an economic or
business cycle (see appendix for details). The data,
shown in Figure 5, again suggests that US equities are
very highly valued today as they have really only ever
exceeded this level during the final blow off stage of
the dot com boom.
35
30
25
20
15
10
5
Source: Sanford Bernstein Quantitative Research, 1974 – 2017
2016
2014
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
0
FIGURE 5:
SHILLER C.A.P.E.
50
45
40
35
30
25
20
15
10
5
Source: Robert Shiller, 1881 – 2017
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2016
2003
1989
1976
1962
1949
1935
1922
1908
1895
1881
0
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5
5. Geometric average of four valuation indicators
Figure 6 comes from Doug Short via the Advisor
Perspectives website and is a geometric average of
the four long term valuation indicators below (see
appendix for details).
• The Crestmont Research P/E Ratio
he Q Ratio, which is the total price of the market
• T
divided by its replacement cost
• T
he relationship of the S&P Composite price to a
regression trendline
The average of the four indicators is currently 94%
(or two standard deviations) above its mean, again
suggesting a significant level of over valuation.
• T
he cyclical P/E ratio using the trailing 10-year
earnings as the divisor
FIGURE 6:
AVERAGE OF THE FOUR VALUATION INDICATORS (GEOMETRIC)
WITH STANDARD DEVIATIONS HIGHLIGHTED
200%
Valuation as at February
2017 Month End
156%
150%
3SD
124%
100%
87%
50%
50%
94%
2SD
83%
72%
SD
41%
MEAN
-13%
-50%
-57%
-49%
-54%
Crestmont P/E from
its Geometric Mean
122%
Cyclical P/E 10 from
its Geometric Mean
88%
Q Ratio from its
Geometric Mean
67%
S&P Composite from
its Regression
98%
Average of the Four
94%
-54%
Recessions highlighted in grey
2020
2010
2000
1990
1980
1970
1960
1950
1940
1930
1920
1910
1900
-100%
Source: dshort.com, 1900 – 2017
6. Market cap/GVA versus S&P 500 10 year total returns
Market cap to GDP is a long-term valuation indicator
that has become popular in recent years, thanks
to Warren Buffett. Back in 2001 he remarked in a
Fortune Magazine interview that “it is probably the
best single measure of where valuations stand at any
given moment.” US fund manager John Hussman
then improved on this index by producing the ratio of
nonfinancial market capitalisation to corporate gross
value added including estimated foreign revenues.
Figure 7 demonstrates the effectiveness of this
measure by mapping the returns implied by the
index against the subsequent ten year returns.
The correlation has been extremely high2, hence
suggesting that this is a reliable valuation tool.
2 See data at top of page 7
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FIGURE 7:
NON-FINANCIAL MARKET CAP / GROSS VALUE ADDED AND CORRELATION
WITH SUBSEQUENT 10 YEAR ANNUAL RETURNS
0.5
25%
20%
15%
1.0
Nonfinancial Market
Cap/Nonfinancial GVA
(LHS)
10 Year annual return
(RHS)
10%
5%
2.0
0%
2006
1996
1986
1976
1966
1956
1946
-5%
Source: Federal Reserve Bank of St. Louis, BEA, 1945 – 2016
None of the measures are market timing tools
In order to discredit even the most reliable valuation
tools, it is quite common for people to make the case
that a valuation doesn’t work usually by showing that
it hasn’t worked over a short time frame. For instance,
writing in the Financial Times this year, Ken Fisher
stated the following:
and implying that it never works. A more scientific
approach would be to take a much longer period (and
hence larger sample size) and then regress valuation
measures against subsequent returns in order to see
which were the most reliable. This is the approach
taken by John Hussman who states:
‘Stocks aren’t overvalued. Valuation techniques are….
Capeists have also cried doom since 2013, when
S&P 500 CAPE neared pre-2008 levels. Now it’s 29.1,
higher than ever except in 1929 and 2000. That’s the
scary hype. Here’s the reality: CAPE was similarly high
in December 1996, inspiring former Fed head Alan
Greenspan’s “irrational exuberance” warning. The S&P
500’s 116 per cent total return over the next 39 months
shows CAPE’s fecklessness.’ 3
“Historically, we find that the least reliable market
valuation measures are the Fed Model [remember that
for later], the raw price/earnings ratio, and the forward
operating P/E. The Shiller P/E (S&P 500 divided by
the 10-year average of inflation-adjusted earnings)
and Tobin’s Q (market capitalisation to net worth at
replacement cost) have substantially better records,
with the ratio of market capitalization to nominal GDP
and the S&P 500 price/revenue ratio having the best
records (having a correlation with actual subsequent
S&P 500 10-year nominal total returns of nearly 90%).”
If you go back to the chart of the Shiller PE in Figure
5, you can see what the writer is doing here which is
taking short periods when the valuation didn’t work
3 For example ‘Stocks aren’t over valued – so keep buying’ by Ken Fisher, Financial Times, 27 March 2017
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-0.76
-0.79
-0.83
-0.85
-0.88
-0.88
-0.89
-0.91
Source John Hussman, Hussman Strategic Advisors Valuations Not Only Mean-Revert; They Mean-Invert September 28, 2015
It seems logical to me to give the greatest
consideration to the valuation measures which
historically have most closely correlated with
subsequent returns and Figure 8 shows where
they stand today. I struggle to look at this chart and
conclude that ‘stocks aren’t overvalued’.
FIGURE 8:
THE MOST RELIABLE VALUATION METRICS ARE CLOSE TO 1999 PEAK
Price/normalised forward
operating earnings
(see Hussman 08/02/10)
200%
175%
150%
Price/10-year earnings
adjusted for profit margins
(see Hussman 05/05/14)
125%
100%
Market capitalisation
of non-financial
equities/nominal GDP
75%
50%
Price/Revenue
25%
Nonfinancial market cap/
Gross Value Added
(see Hussman 05/18/15)
0%
-25%
-50%
2016
2012
2009
2006
2003
1999
1996
1993
1990
1986
1983
1980
1977
1973
1970
1967
1964
1960
1957
1954
1951
1947
-75%
S&P 500 forward operating earnings and revenues imputed prior to 1980 based on estimated relationship
with other observable data series.
Source: Hussman Strategic Advisors, 1947 – 2017
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The Fed Model
When faced with valuation charts which almost
universally make equities look expensive, the last
resort is to compare them to bonds. Now when my wife
tells me I need to go on a diet and I reply that relative
to Luciano Pavarotti at his heaviest, I still look quite
trim, she tends to disregard my protestations. Similarly,
if someone has to use an asset class like bonds which
is at a several hundred year valuation high in order to
make equities look cheap, then I think the alarm bells
should start ringing (see Figure 9).
FIGURE 9:
AVERAGE LONG-END SOVEREIGN BOND YIELD
Average of US, Japan,
Germany and UK
14
12
10
8
6
4
2
2011
2016
2007
2001
1997
1994
1991
1987
1985
1983
1980
1977
1974
1970
1963
1959
1954
1944
1932
1924
1922
1914
1898
1880
0
Source: Minack Advisors, 1880 – 2016
The comparison of equities to bonds as a valuation
tool is known as ‘The Fed Model’ although interestingly
the Federal Reserve has never endorsed its use.
On July 22 1997, The Fed’s “Humphrey-Hawkins
Report” introduced a graph of the close relationship
between long-term Treasury yields and the forward
earnings yield of the S&P 500 from 1982 to 1997.
Shortly thereafter, in 1997 and 1999, Ed Yardini at
Deutsche Morgan Grenfell published several research
reports further analysing this bond yield/stock yield
relationship. He named the relationship the “Fed’s
Stock Valuation Model”, and the name stuck.
FIGURE 10:
EQUITY VALUATION AND LONG-TERM INTEREST RATES
Ten-year Treasury note
yield
Monthly
S&P 500 earnings-price
ratio
14%
10%
6%
July
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
2%
Source: Federal Reserve Humphrey Hawkins Report, 1982 – 1997
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The basic proposition of the Fed Model is a competing
assets argument which suggests that there is a
stable relationship between bond yields and earnings
yields on equities. From here it follows that when the
earnings yield is higher than the bond yield, equities
are said to be cheap and vice versa. There are three
reasons people use the Fed model. Firstly, it appears
to have worked in the short term, secondly it appears
to be backed by financial theory4 and finally, it’s easy to
use. I will show that it is only the last point of the three
which is valid.
9
In the rest of this note, I will make the following points:
1. There is no empirical relationship between nominal
bond yields and PEs
2. There is no empirical relationship between real bond
yields and PEs
I will finish by showing there is a
3. However
relationship between interest rate changes and
share price changes. The conclusion of this is that
the decline in interest rates may have led to the rise
in equity PEs but that is the opposite of saying that
today’s low interest rates make equities look cheap.
1. There is no empirical relationship between nominal bond yields and earnings yields
disinflationary period 1982 to 1998 which is shown in
Figure 11. Thus Fed Model enthusiasts are anchoring
on one period when the model worked whilst choosing
to ignore the many other periods when it did not.
When viewed on a long term basis, the correlation
between earnings yields and bond yields has
frequently been negative as shown in Figure 11. The
presumed one-to-one relationship between bond
yields and earnings yields is wholly an artefact of the
FIGURE 11:
FED MODEL IS AN UNRELIABLE VALUATION TOOL IN THE LONG TERM
20%
S&P 500 forward
operating earnings yield
Monthly
14%
18%
10-year Treasury bond
yield
10%
16%
6%
July
14%
1997
1992
12%
1987
1982
2%
Ten-year Treasury note yield
S&P 500 earnings-price ratio
10%
8%
6%
4%
2%
2016
2013
2010
2007
2003
2000
1997
1994
1991
1988
1984
1981
1978
1975
1972
1969
1965
1962
1959
1956
1953
1950
1946
1943
1940
0%
S&P 500 forward operating earnings imputed prior to 1980 based on estimated relationship with other observable data series.
Source: John Hussman, Hussman Strategic Advisors, 1940 – 2017
4 This is the NPV argument i.e when the discount rate in a DDM or DCF falls, the NPV should rise
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The fact that there is no relationship should come as
no surprise to us since bonds are a title to interest and
capital payments which are fixed in nominal terms,
whilst equities are a title to the ownership of real
assets. It would actually be surprising if there was
a strong relationship between the two.
The theoretical justification for the Fed Model is that
the value of equities is the NPV of a future stream of
cash flows discounted back to today at an appropriate
discount rate which usually incorporates the bond
yield plus a risk premium. Hence the theory would
be that the lowered bond yield, ceteris paribus,
would justify a higher value for equities. This can
be demonstrated using the simple Gordon’s Growth
Model as shown below.
Price =
D1
r–g
Where D1 is the dividend, r is the discount rate and
g is the growth rate.
Hence if D1 = £10 and the discount rate r=9% and
growth 4% then the price is £200. If this rate r falls to
6% but the growth rate remains the same, then value
P rises to £500 (£10/(0.06-0.04)). This would appear to
justify the Fed Model.
The flaw in this argument is that it assumes that the
flow of cash remains unchanged following the decline
in bond yields whereas the reality is that changes in
bond yields usually reflect changes in expectations
about future inflation. If expectations about future
inflation are falling, then it is likely that the growth in
the cash from equities (g in the equation above) will
also decline and hence the reduction in the interest
rate is offset by the reduction in growth (see appendix
1 for further details). Thus it is understandable why
people might believe that the Fed Model is backed by
financial theory but the reality is quite different.
2. There is no empirical relationship between real yields and earnings yields
one would expect to see a relatively constant equity
risk premium as this would mean that as real yields
fell, equities would do well by virtue of the earnings
yield declining.
In his book ‘Wall Street Revalued’ Andrew Smithers
showed that there was no relationship between real
bond yields and earnings yields5. The chart below
shows the equity risk premium i.e the excess return
on equities over the return on bonds in real terms.
If real bond yields influenced equity returns, then
In reality, the equity risk premium is anything but stable.
FIGURE 12:
UK AND US REAL EQUITY MINUS REAL BOND RETURNS
Real equity returns minus real bond
returns over 15 years
20
US
UK
15
10
5
0
-5
1997
1982
1967
1952
1937
1922
1907
1892
1877
1862
1847
1832
1817
-10
Source: Siegel, DMS. 1817 – 2000
5 Wall Street Revalued by Andrew Smithers 2009 ‘3.2 Real Bond Yields and PEs’
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More recently, James Montier at GMO showed the following chart which mapped equity PE ratios against real
yields and again demonstrated no relationship.
FIGURE 13:
EQUITY PE RATIOS VERSUS REAL YIELDS
Shiller P/E
45
40
35
30
25
20
15
10
5
0
-6
-4
-2
0
2
4
6
8
Perfect Foresight 10-Year Real Interest Rates
Source: GMO, January 2017
So in practice, the Fed Model doesn’t seem to hold whether using nominal or real bond yields.
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3. There is a relationship between changes in interest rates and changes in stock prices
In his paper ‘Fight the Fed Model’ Cliff Asness of
AQR showed that future equity returns are highest
in decades that start with high rates and lowest in
decades that start with low interest rates (see Figure
14 in which lowest interest rate quintile are in 1 and
highest interest rate quintiles in 5). This is often
because the high rates are associated with recessions
and low equity valuations but by the time the recession
is over, equity markets have moved from cheap to
expensive.
FIGURE 14:
S&P 500 Decade-Long Real Return Sorted by Interest Rates
Price 10-Year Real
Return
14%
12%
Future 10-Year Real
Return
10%
8%
6%
4%
2%
0%
-2%
-4%
1
2
3
4
5
Source: Fight the Fed Model by Cliff Asness 2003, 1965 – 2001
The Fed Model is saying that equities are cheap
because interest rates are low whereas the reality is
actually the opposite; equities have become expensive
because interest rates are low. Asness uses a terrific
analogy to demonstrate this point:
“Say you can show that teenagers usually drive
recklessly after they have been drinking. This is
potentially useful to know. But, it does not mean that
when you observe them drinking, you should then
blithely recommend reckless driving to them, simply
because that is what usually occurs next. Similarly, the
fact that investors drunk on low interest rates usually
pay a recklessly high P/E for the stock market (the
Fed model as a descriptive tool) does not make such
a purchase a good idea, or imply that pundits should
recommend this typical behaviour (the Fed model as
forecasting/allocation tool).”
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Conclusion
In this note we have shown that, using the most
reliable long term measures of valuation, US equities
look very expensive. This is, of course, one of the
reasons for the high cash balances and put protection
on many of our funds today.
Secondly, we have tried to show that low interest rates
do not make equities look cheap by demonstrating
the flaws in the Fed Model. It is fine for investors to
compare the zero percent real returns baked into
equities and then compare those to bond yields or to
suggest a pair trade of long equities short bonds based
on relative valuation. It is wrong, however, to suggest
that equities will produce good returns from this level
of valuation ‘because interest rates are low’.
More astute investors than I have been pointing out
the academic and empirical flaws of the Fed Model
for fifteen years.6 Despite this it remains an almost
daily occurrence to read or hear some market pundit
telling investors to ignore all the other valuations
that make stocks look expensive because ‘they look
cheap relative to bonds’. It seems unlikely that this will
change any time soon.
I will leave the last word to Andrew Smithers who felt
so passionately about trying to correct some of the
abuses of equity valuation that he wrote a book about
it (which despite being eight years old is still highly
recommended):
“
Among investment bankers and
financial journalists, the two most
common claims to value are…
unadulterated nonsense. One of these
is that “shares are cheap given the
current (forecast) PE multiples” and
the other is that “shares are cheap
relative to interest rates”. As popular
views influence economic policy, it
is important that popular nonsense
should be exposed rather than
ignored.
”
ANDREW SMITHERS, WALL STREET REVALUED 2009
6 Asness 2003, Smithers 2009, Hussman 2007-2017
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Appendix 1
Why the Fed Model doesn’t work
(the following are a simplified version taken from ‘Fight the Fed Model’ by Cliff Asness, AQR)
Let us start with the proposition that equity returns are the sum of the dividend yield plus the growth in income.
E(R)= D/P + GD where E (R) is nominal equity return, D is dividend, P is price GD is growth in dividend
Now we can substitute the dividend yield for the payout ratio (PAY) multiplied by the earnings yield
E(R)= PAY X E/P + GD
In the long run, the payout ratio for equities has been about 50% and earnings growth and dividend growth have
been about the same so substituting them in we can say the following
E(R)= 0.5 x E/P + GE in other words, nominal equity return is half the earnings yields plus growth in earnings
Next, we can state that real equity returns are nominal returns less inflation which can be stated as follows
E(r) = E(R) – I where E(r) is real equity returns and I is inflation
Substituting in the equation from above,
E(r)= 0.5 x E/P +GE – I
So E(r)= 0.5 x E/P + gEwhere gE is real growth in earnings
This makes sense; what this last equation is stating
is that real equity returns are a function of the starting
valuation (measured here as the earnings yield) and
the real growth rate of earnings.
At this point we have to make two assumptions, firstly
that when the inflation rate falls, the bond yield will
also fall in a one to one relationship. Secondly, let’s
also assume a fall in nominal returns on equities.
This is logical since if nominal stock returns were
10% in a 5% inflation environment (i.e. a 5% real
return), it is unlikely that they would remain at 10%
in a 2% inflation environment (i.e. real returns would
go up to 8% real). A more reasonable assumption is
that nominal returns would fall to 7% and hence real
returns would remain at 5% real.
So when inflation and bond yields fall, if nominal
equity returns are to decline (in order for real returns
to remain the same) there are two ways this could
happen. The first is that E/P could fall (or P/E’s rise)
which is essentially what the Fed model advocates.
The other possibility, is that the growth rate declines
which appears to be the more likely scenario. In
essence, this is suggesting that nominal earnings
growth falls in line with inflation although real earnings
growth remains unchanged.
Asness tested the relationship between nominal
earnings growth and inflation over the period 1926
to 2001 and found that 94% of decade-long inflation
showed up in nominal earnings growth. Anyone
who holds equites in the belief that equities are an
inflation hedge effectively believes this point – they
are anticipating that in the event of higher inflation,
nominal earnings growth will rise in line leaving real
earnings growth unchanged. In other words, when
nominal bond yields fall, it is not the earnings yield that
adjusts but the nominal growth rate in earnings.
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Appendix 2: Details on valuation methodologies used
Shiller P/E ratio
Q ratio
This methodology uses the actual reported earnings
per share for the S&P 500 Index over trailing forty
quarters (i.e., ten years). The quarterly EPS data is
then interpolated to monthly values. Each value in
the series is adjusted to today’s dollars by historical
inflation (i.e., into real terms).
The Q Ratio is a popular method of estimating the
fair value of the stock market developed by Nobel
Laureate James Tobin. It’s a fairly simple concept, but
laborious to calculate. The Q Ratio is the total price
of the market divided by the replacement cost of all
its companies. Fortunately, the government does the
work of accumulating the data for the calculation. The
numbers are supplied in the Federal Reserve Z.1
Financial Accounts of the United States of the United
States, which is released quarterly
Additionally, Shiller calculates a market price index
for each month based upon the average daily closing
price of the S&P 500 Index across the month. Each
month’s value for the market index is adjusted to
today’s dollars by historical inflation.
The P/E for each month is calculated based upon
that month’s price index and the trailing ten years
of inflation-adjusted EPS data. As a result, P/E10
provides a measure of market valuation that excludes
the distortions of inflation and mutes the variability of
the business cycle
Crestmont P/E
The Crestmont approach uses the fundamental
relationship between gross domestic product (“GDP”)
and earnings. The fundamental relationship is driven
by two elements. First, GDP essentially represents
composite revenues. Second, profits emanate from
revenues. Therefore, over time, profits grow in line with
economic growth.
Although economic growth has some variability,
earnings has its own cycle from the business cycle of
competitive market forces. It is the second cycle that
most affects EPS due to its frequency and magnitude.
Over time, however, EPS reverts back to its baseline
relationship to GDP. Economists recognise that the
profit margins cycle is one of the most mean reverting
cycles in the economy. Therefore, profits (as reflects
in EPS for public companies) has a strong and
fundamentally-driven relationship with GDP.
The Crestmont approach for a normalised P/E uses
overlapping fifty-year regressions between nominal
GDP and actual reported EPS to generate a series
for EPS based upon historical and estimated future
nominal GDP. This methodology mutes distortions from
the business cycle, while generating a current value
for normalised baseline EPS.
Regression to trend
About the only certainty in the stock market is that,
over the long haul, over performance turns into under
performance and vice versa. This methodology applies
regression analysis on the S&P Composite stretching
back to 1871 based on the real (inflation-adjusted)
monthly average of daily closes. The regression
trendline drawn through the data clarifies the secular
pattern of variance from the trend — those multi-year
periods when the market trades above and below
trend.
Market Capitalisation to Gross Value Added
Created by John Hussman as a way of improving on
Market Capitalisation/GDP where the main weakness
is that the GDP doesn’t include the income of U.S.
income generated overseas and does include the
income of foreign companies (which presumably
are not listed on the U.S. markets). To adjust for
this, Hussman uses GVA (gross value added)–GDP
is essentially (GVA – sales taxes + subsidies), and
adjusts that for foreign profits to get a more reflective
measure. GVA can be found in Federal Reserve
Z.1 Flow of Funds statistics. All in all, Hussman comes
up with Adjusted GVA, which is Domestic GVA *
(1 + ROW profits)/(domestic profits). This relationship
–Market Capitalisation/(Adjusted GVA) is better
correlated to the S&P returns.
RWC Partners Limited 60 Petty France, London SW1H 9EU | T +44 (0)20 7227 6000 | F +44 (0)20 7227 6003
Bibliography
Wall Street Revalued: Imperfect Markets and Inept Central Bankers by Andrew Smithers 2009
Fight the Fed Model: The relationship between future returns and stock and bond market yields by Clifford
Asness of AQR 2003
Six Impossible Things Before Breakfast by James Montier, GMO, March 2017
Various by John Hussman, Hussman Strategic Advisors including ‘The Most Broadly Overvalued Moment in
Market History 6th March 2017
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