Reply #22: Omitted Variables (Hussman) [View All]

[54anickel]

http://www.hussmanfunds.com/wmc/wmc050822.htm

One of the nearly indelible assumptions about the current stock market is that valuations “deserve” to be high because interest rates and inflation are reasonably low. It accords with common sense that since stocks compete with bonds, lower interest rates should generally be accompanied by higher price/earnings multiples (and accordingly, lower future returns on stocks).

There's certainly some validity to this argument. We can observe, for instance, that as interest rates have declined since 1980, earnings yields (the inverse of P/E ratios) have also declined. This is conveniently summarized in the “Fed Model”, which assumes that the prospective earnings yield on the S&P 500 (on the basis of expected operating earnings) should be equal to the 10-year Treasury yield.

Unfortunately, the Fed Model dramatically overstates the relationship that exists between interest rates and justified stock valuations. Stock valuations began in the early 1980's at what were, objectively, very undervalued levels. Indeed, the price/peak earnings ratio for the S&P 500 Index fell below 7 in August 1982. Over the following two decades, stock valuations moved up to extremely high valuations, peaking at over 30 times earnings during the recent market bubble.

In other words, as interest rates declined, so did earnings yields. But a major portion of that decline in earnings yields represented a long movement from extreme undervaluation to extreme overvaluation, not a “fair value” relationship with interest rates.

What's really going on here is something called “omitted variables bias.” The Fed Model explains the decline in stock yields since 1980 with one variable – the 10-year Treasury bond yield. But in fact, there are two variables at work. One is the declining level of interest rates, sure. But the other is the move from deep undervaluation to extreme overvaluation – in other words, a profound decline in the “risk premium” that stocks have been priced to deliver, over and above what bonds could be expected to return. In 1982, the risk premium on stocks was huge. At present, it's close to zero, and possibly negative.

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