Hussman Drops the P Word

by Fitzroy McLean on October 11, 2010

Fitz here.  It isn´t often that a mutual fund manager has the gumption to tell it like it is.  For the most part, the mutual fund industry is comprized of fee collecting conformists who live and die by market sentiment.  Market is ¨hot¨ and the funds roll in along with the fees.  Market is ¨not hot¨and the money flows the other way and the bigger house in the Hamptons has to wait another few years.  So naturally the majority of the mutual fund crowd are cheerleaders for their own book. So when I came across John Hussman´s rant, which admittedly sounds like one of my own, I thought it deserved wider distribution.  Surely you can make the argument that Hussman is only talking his own book in a round about way.  Perhaps.  To my mind his way seems a lot ¨straighter¨ than most. Let me know what you think.

If you look through market history prior to the valuation bubble that began in the mid-1990′s, you will observe only three times that the dividend yield on the S&P 500 dropped to 2.65%. The precise dates should be instantly familiar. August 1929, December 1972, and August 1987. These dates represented the peaks prior to the three worst market plunges of the 20th century.

Prior to the mid-1990′s, the median dividend yield on the S&P 500 had been about 4.1%. Then, the market launched into what would ultimately become a valuation bubble, followed by a decade of dismal returns for investors. Since then, the dividend yield on the S&P 500 has regularly dipped below 2.65%, and as of last week, had dropped to just 2%.

It is not a theory, but simple algebra, that the total return on the S&P 500 over any period of time can be accurately written in terms of its original yield, its terminal yield, and the growth rate of dividends. Specifically,

Total annual return = (1+g)(Yoriginal/Yterminal)^(1/T) – 1 + (Yoriginal+Yterminal)/2

As it happens, the long-term growth rates of S&P 500 dividends, earnings (measured peak-to-peak across economic cycles) and other fundamentals have been remarkably stable for more than 70 years, at about 6% annually, with very little variation even during the inflationary 1970′s. Even if one includes the depressed yields of the bubble period, and restrict history to the post-war period, the median dividend yield is 3.7%. Thus, a reasonably good estimate of future 7-year total returns for the S&P 500 is simply:

Total annual return = (1.06)(Yoriginal/.037)^(1/7) – 1 + (Yoriginal + .037)/2

At a 2% dividend yield, this estimate is currently -0.07%.

For historical perspective, the chart below presents the 7-year projected total returns obtained in this manner in blue. The actual subsequent 7-year total return for the S&P 500 is depicted in green. Notice that the performance of this method deteriorated significantly after about 1988, reflecting the fact that terminal yields 7 years later began to depart dramatically from prior historical norms.


In order to understand the departure of that green line (actual 7-year returns) from the blue line (expected 7-year returns), it is important to recognize the effect of bubble valuations in the period since the mid-1990′s. One way to understand this impact is to ask the counterfactual question: what would the actual returns of the S&P 500 been if the dividend yield had not broken below the 2.65% level that defined past historical market peaks?

The answer to that question is depicted below by the red line. It presents actual historical 7-year S&P 500 total returns with one restriction. For 7-year periods that ended at a dividend yield of less than 2.65%, the red line presents what the 7-year return would have been if the terminal yield was limited to a 2.65 lower bound.


Here’s the kicker:

The difference between the green line and the red line represents the effect of bubble valuations. Had it not been for a period of sustained bubble valuations (which ultimately proved themselves to be bubble valuations by creating a 13 year period of dismal subsequent returns), we find that the yield-based model above would have extended its admirable historical record.

This creates a terrible problem for investors here. Given that the yield on the S&P 500 is now below 2%, it is essential for investors to recognize that they now rely on the achievement and maintenance of sustained bubble valuations in the years ahead. Unless investors believe that bubble valuations can be maintained indefinitely, they can expect little but abysmal returns over the coming 5- 7 year period.

Fitz again. And here is my favorite part:

The global financial system continues to be unsound in the same way that a Ponzi scheme is unsound: there are not enough cash flows to ultimately service the face value of all the existing obligations over time. A Ponzi scheme may very well be liquid, as long as few people ask for their money back at any given time. But solvency is a different matter – relating to the ability of the assets to satisfy the liabilities.

How many fund managers have the guts to actually call a ponzi scheme a ponzi scheme?  That is normally left to the flamboyant trending towards obnoxious newsletter writers like yours truly.  If  you want to read the rest of Hussman´s letter it is available here.   You can find out more about Hussman and his funds at


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