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January 9, 2006

Do P/E Ratios Expand Once the Fed is Done?

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

It's sometimes interesting what passes for common knowledge. Last week, for example, anyone watching the business channel would have eventually taken it as an article of faith that “once the Fed is done tightening, P/E multiples expand.”

It sure sounds reasonable. Get the last rate hike out of the way, and stock valuations should increase. Isn't that obvious? Well, it might be, except that it doesn't really show up in the data. Though the bulls are evidently OK with the whole “Finish with the Fed and away we go” thesis, I'm just not comfortable basing investment positions for my shareholders on notions that don't have any evidence to support them.

The data on this is a continuation of what I presented in the December 19th analysis (What Happens When the Fed is Finished?) The fact is that in the 13 tightening cycles since 1950 (comprising two or more consecutive rate hikes), the P/E ratio for the S&P 500 was flat or lower, on average, over the following 6-12 months.

Now, if we move to a longer horizon, we do see at least some positive tendency for P/E ratios to increase. Specifically, the P/E ratio for the S&P 500 rose by an average of 11% in the 18 months following the final rate hike of a tightening cycle. That's got to be good for some above-average investment returns, no?

Well, no. Unfortunately, over the same 18 month period following the final rate hike, S&P 500 earnings actually declined an average of -3.4%. Combining the two effects – a modest increase in the P/E with lower earnings, and adding dividend income, the average total return on the S&P 500 during the 18 month post-tightening period was 13.1%, or 8.5% annualized, which is actually a below-average return on a historical basis. So the unfortunate fact is that the prospect of the Fed being done has no particular bullish implication at all.

Moreover, if we parse the data by valuation, it turns out stocks historically performed even worse if stock valuations were elevated when the tightening cycle ended. For example, if the price/peak earnings ratio on the S&P 500 was greater than 12 at the point of the last rate hike, the (raw) S&P 500 P/E ratio still expanded by 12% over the following 18 months, but that was largely because earnings (the denominator) declined by an average of -6.4%, providing a total return, including dividends, averaging 8.9% over the 18 month period (just 5.9% annualized).

If we restrict valuations to a price/peak earnings multiple of 16 or higher (the current multiple is 19), we find that on average, S&P 500 earnings declined by -8.6% over the 18 months after the final rate-hike. Yet despite this decline in earnings (which would normally raise the raw P/E ratio if prices were to remain constant), the raw P/E ratio actually declined as well, by an average of -1.3%. The result was an average loss, including dividends, of -6.5% over the 18 month period (an annualized loss of -4.4%).

Suffice it to say that the bullish argument – based on the “common knowledge” that P/Es expand once the Fed is done tightening – really has no data to support it. Nor is there data to support the notion that corporate earnings have grown at all in the period after a tightening cycle, particularly when those earnings began at fresh records at the top of their long-term historical 6% growth channel (as they currently reside).

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations. Though the quality of market action still did not provide sufficient evidence that investors have adopted a robust preference toward risk taking, there was in fact some measurable improvement. A continuation of that, were it to occur at even higher price levels, would not prompt a materially large shift in our market exposure since stocks are already quite overbought, but an initial exposure of between 10-15% of portfolio value would be acceptable. A further exposure would be warranted if the market then experienced a normal pullback or oversold condition, and the quality of market internals was to remain intact. Those are admittedly a lot of “if” and “in case of” considerations, but the general principle is simple: an improvement in the quality of internal market action warrants an immediate and substantial increase in market exposure if valuations are favorable, and a positive but more measured increase in market exposure to the extent that valuations are elevated or short-term conditions are overbought, or both (as is the case at present). For now, the Strategic Growth Fund remains fully hedged, but at least some amount of market exposure would be acceptable if internals continue the improvement that we've seen in recent sessions, and even as much as a 30-40% unhedged stance if such an improvement was to be sustained in the face of a pullback to short-term oversold conditions.

In bonds, the Market Climate remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Total Return Fund to a short 2-year duration, mostly in Treasury Inflation Protected Securities. The most important move in the Strategic Total Return Fund last week was prompted by the spike in precious metals share prices, which moved me to reduce the Fund's position in these shares from just under 20% of assets to just over 10% of assets. Last week, the Philadelphia Gold Index (XAU) closed at 139.86, having advanced nearly 70% since its May 2005 trough (see The Sound of One Hand Clapping - May 2, 2005). The reduction in our exposure is not in any way a “bearish call” or “sell signal” on precious metals shares. Rather, it is always my approach to accept exposures that are in line with the probable return/risk tradeoff in various markets. The recent spike in gold shares took those securities both to more reasonable valuations (itself a reason to clip a portion of our exposure) and to a substantially overbought condition on an intermediate term basis. The reduction in exposure to a smaller but still positive level reflects a similar change in my evaluation of the return/risk profile for precious metals shares here.


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