John Hussman Asks Why Michael Darda Shaved Off His Beard, Explains Why NIPA Profits Are Completely Irrelevant
Courtesy of Tyler Durden
Two weeks ago John Hussman appeared on CNBC in a segment in which he had the (dis)pleasure of deconstructing Michael Darda’s permabullish argument, which has been virtually unchanged and cosmetically rehashed ever since Darda went John Holmes in 2007 at the very peak of the market (Hussman also sparred against James Altucher, but that was pure torture under any iteration of the Geneva Convention or the Basel Treaty, and we will spare our readers the result – masochists can see the clip here). 30% lower and nothing has changed. Which is why in his daily letter, Hussman has some much needed qualifiers to debunk the Darda argument which is as wrong now as it has always been. Tangentially, Hussman has a question for Darda: “just before the market plunged by more than half, [Darda] asserted “the fundamental underpinnings of stocks are superb.” He later appeared on CNBC in January 2008 sporting a beard, asserting that all of the recession talk was overblown, and telling a reporter at TheStreet that he would not shave the beard “until the recession talk ends or housing recovers, whichever comes first.” As of a couple of weeks ago, he had no beard, which was perplexing.” Hopefully Larry Kudlow can ask this question of Darda (and AJ Cohen) next time he has his favorite permabullish cheerleader brigade on deck. The full clip of Hussman’s unfortunate encounter with a very clean shaven, and oddly smug, Darda can be seen here.
Here is Hussman’s latest deconstruction of the groundless arguments presented by an increasingly more desperate cadre of bullisht [sic] disseminators.
A couple of weeks ago, I was in a CNBC segment discussing economic conditions. I decline the vast majority of media requests, but I thought it was important to talk about the economic risks we’re observing. It was a debate-style format with another analyst who essentially recapped the same arguments that he made at the 2007 market peak. Indeed, just before the market plunged by more than half, he asserted “the fundamental underpinnings of stocks are superb.” He later appeared on CNBC in January 2008 sporting a beard, asserting that all of the recession talk was overblown, and telling a reporter at TheStreet that he would not shave the beard “until the recession talk ends or housing recovers, whichever comes first.” As of a couple of weeks ago, he had no beard, which was perplexing.
Now, while I have difficulty with analysts who repeatedly lead investors down the primrose path to abominable losses, my defensive approach has also left enough on the table from time to time that I don’t want to throw stones. Still, one feature of his analyst’s argument was different from 2007, and the more I’ve thought about it, the more I realize how damaging it could be to investors, so I think it’s important to discuss. Specifically, instead of using forward operating earnings to assert that stocks were cheap, he based his valuation assessment this time on NIPA profits (from quarterly GDP accounting). Quoting NIPA profits in the context of market valuations struck me as odd, but the segment immediately jumped to another question. Part of the reason I don’t do much TV. You can’t thoughtfully discuss the financial markets in 20-second sound bites.
Here are the basics. NIPA profits (from the National Income and Product Accounts, compiled by the Bureau of Economic Analysis) are a quarterly measure of economy-wide profits, restricted to current production, less associated expenses. As economists at the Department of Commerce and the BEA have noted (Mead, Moulton and Petrick, 2004), this measure of earnings deviates substantially from S&P 500 earnings. Expenses used in the calculation of NIPA profits exclude bad debts, resource depletion, disposition of assets and liabilities, capital losses, and any deductions relating to the treatment of employee stock options. It also includes an allowance for misreporting of corporate income. Many of these calculations are only available on an annual basis, with a considerable lag, and as a result, quarterly NIPA profit estimates and revisions make significant use of interpolation and extrapolation.
Moreover, the NIPA estimate deviates from S&P 500 earnings not only because it excludes all sorts of expenses that are relevant to shareholders, but also because it covers the entire universe of U.S. companies, including small businesses, Sub-S corporations, and mid-sized companies that are not in the S&P 500. Indeed, S&P 500 earnings as a share of NIPA profits have fluctuated between 38% and 85% over the past couple of decades. Except for a slight amount of predictable mean reversion when S&P 500 net income declines during recessions, there is no correlation at all between divergences between NIPA profits and S&P 500 earnings (net or operating) and subsequent changes in S&P 500 earnings. So they aren’t reliably predictive of anything.
In short, the NIPA profit estimate is a frequently revised, noise-ridden, extrapolation-based quarterly data point, reported with a substantial lag, that excludes a host of shareholder-relevant expenses, and covers a broadly different universe of companies than does the S&P 500. So I’ve been asking myself, why would anyone want to use NIPA profits to value the market, instead of using actual earnings reports, or even forward operating earnings which are already a sufficiently overblown measure of corporate performance? The only answer I can come up with is that NIPA profits are an even more overblown and misleading measure, allowing the continued assertion that stocks are undervalued.
To give you some idea of the distinction, the following chart shows S&P 500 earnings (TTM) versus NIPA profits, scaled so that each series begins at the same value in 1963. Notice that in 1963, both measures would have (by construction) given you the same P/E multiple. But presently, the NIPA line is over 60% higher than the net earnings line (the same is true for 10-year averages), so any P/E based on NIPA profits is substantially and misleadingly low. Again, earnings reports for the S&P 500 companies are directly available. The NIPA figure does not even cover the same universe of companies as the S&P 500, and excludes a whole host of relevant expenses. In effect, by using NIPA profits, you gradually skew the profile of valuations over a period of decades so that what would normally represent clear overvaluation today is transformed into something that looks soothingly appropriate. It is not.
We are grateful that people like Hussman exist, and to at least try to stop the toxic Kool Aid from flowing and destroying the net worth of all those who naively follow the status quo cheerleading lemmings, most of whom have not had an original idea in the past decade, whose advice was wrong then, is wrong now, and will continue to be wrong with virtually 100% certainty.
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