$$ Davidson Takes on Hussman

• Posted by ToddSullivan
• on July 7th, 2010

I think readers know where I fall….

In response to Hussman’s piece:

“Davidson” retorts:

I hope this is not too complicated, but there are many issues here with Hussman’s work and that of ERCI. One can never take at face value what some analyst says unless one has taken some time to determine all the facets (or at least as many as possible that seem significant) of that individuals analysis.

I took some time to read Hussman’s piece. I extracted a quote from it below. Hussman makes the classic mistake of comparing market pricing of one period to another without understanding the economic dynamics. One cannot compare economic and investment periods using his simple analysis. His analysis misses the basic fact that a combination of Real GDP and inflation is the basis for market valuation, a market cap rate (MCR). Investors in seeking securities that will provide competitive returns inherently use future Nominal GDP expectations in their rates of return calculations. Most investors are not even aware that they do this.

The calculation works like this. One makes and estimate of Nominal GDP and then compares this to the return expected from the underlying business as it “flows through to the security” For example, if one expects Burlington Northern(BNI) to move from a rising ROE trend of 19% today to 25% in 5yrs then if you buy into it at 2XBook Value as Buffett’s 2008 puts let him buy additional stock in the low $70s/shr range, then he was investing capital at a 9.5% return with the expectation that he might achieve a 12.5% return on his capital in 5yrs. He did this with the current. The MCR at the time he made his initial buy was just under 5% which meant that he believed he would get a return some 90% higher than the marketplace average. Buffett thinks long term and he believes that inflation is understood by the Fed to be a human caused situation and that Bernanke knows this. Buffett believes that Bernanke is not going to inflate which means Nominal GDP in the range of 4%-5% for decades or lower. This means that the MCR will support a valuation level of his BNI purchase in the range of 5x to 6.25x Book Value at a 25% ROE.

So….following the thought process…Buffett buys at 2x BV…inflation remains controlled…BNP continues its pace of efficiency and produces ROE 25% in 5yrs and Buffett can justify valuing the Book Value per share which has moved from $35shr to $100shr at $500 to $625. When one views investments over history within the context of the MCR, one understands the rationale of Buffett’s purchase of BNI.

Hussman has not incorporated the MCR as a market valuation parameter. He misses the point that June 1950, Sept 1974 and July 1982 were each high inflation periods which made the Real GDP + inflation = ~14% or so. The effect on market valuations is to force prices down to 7 P/E or a 14.29% SP500 Earnings Yield which each of those periods reflected. Today the MCR is 4.08% and falling which justifies a market P/E of 24.5. The market could be priced at this level if investor psychology were to turn substantially more to the positive side.

His portfolio is Long/Short and his turnover is ~70% annually according to Morningstar. He is a trader. His perspective is short term as is his research and market perspective.

“Moreover, from a valuation standpoint, a further market trough would not even be “out of sample” in post-war data. Based on our standard valuation methods, the S&P 500 Index would have to drop to about 500 to match historical post-war points of secular undervaluation, such as June 1950, September 1974, and July 1982. We do not have to contemplate outcomes such as April 1932 (when the S&P 500 dropped to just 2.8 times its pre-Depression earnings peak) to allow for the possibility of further market difficulty in the coming years. Even strictly post-war data is sufficient to establish that the lows we observed in March 2009 did not represent anything close to generational undervaluation. We face real, structural economic problems that will not go away easily, and it is important to avoid the delusion that the average valuations typical of the recent bubble period represent sustainable norms.”

In short Hussman’s reasoning misses the fundamental aspects of market pricing. By my reading and analysis of the ERCI WLI, although the authors do not reveal their proprietary methodology, I am convinced that selected equity price inputs contribute heavily to its composition. My suspicion is that these equity prices include construction, engineering and natural resource companies. See charts below.

Additionally, the recent collapse in the WLI (peak April 30, 2010) coincides with the peak in oil stocks including BP which has fallen quite sharply recently. This is in the face of increasing global trade, increasing auto sales, increasing employment (see the up-turn in Household Survey data below), increasing personal income, falling debt loads and a number of fundamentals reflecting economic up-trends.

One always needs to delve into how a forecast was derived to ascertain where and how the forecaster gets and applies his information. I disagree with Hussman and even with the ERCI WLI both of which are using market prices a guide to economic activity. The belief that markets forecast the economy is the greatest myth of our age in my view. The truth lies in the reverse.

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