**From an analytical perspective, nothing affects the stock market except by affecting these three factors: dividend payouts, earnings growth, and P/E ratios.**The primary effect of interest rates is on the P/E ratio. Falling interest rates encourage falling earnings yields (higher P/E ratios). Rising interest rates encourage rising earnings yields (lower P/E ratios). These effects are strongest when P/E ratios begin at extreme levels.

**"1) Returns due to dividend income have never been lower...**

**"2) Earnings are near the peak of their long term growth channel...**

**"3) Stock prices have never traded at a higher multiple of peak earnings...**

**"Add these factors together, and investors face a long term total return of 7% annually if P/E multiples remain fixed at record highs,**If the P/E contracts toward normal levels instead, stocks may very well under-perform Treasury bills for more than a decade (as they did from 1965 through 1986)."

*and*earnings grow along the peak of their long-term growth channel.*even*a future price/peak earnings ratio of 20 could have been expected to result in a nearly zero annualized returns over the following 10 years. Not surprisingly, in the 5 years since the 2000 market peak, the S&P 500 has actually produced a total return of about –2% annually. The likelihood is that the coming 5 years will not be substantially better.

**"Presently, the likely range of S&P 500 annual total returns for the coming decade is in the 2-3% range based on average and median scenarios, with outside possibilities as low as -3% in the very bearish case and still less than 8% in the very bullish case. "**

**"From an analytical perspective, nothing affects the stock market except by affecting these three factors: dividend payouts, earnings growth, and P/E ratios. **The primary effect of interest rates is on the P/E ratio. Falling interest rates encourage falling earnings yields (higher P/E ratios). **Rising interest rates encourage rising earnings yields (lower P/E ratios). These effects are strongest when P/E ratios begin at extreme levels."**** **

I added the large and bold font for the last sentence. If the last twenty years of falling interest rates saw the long term treasury bond annualized gains surpass stock gains, and if rates may well start to rise, especially if the on-going world-wide reflation attempts succeed, what will that do to stock returns for the next ten years? Stock P/E ratios have fallen this year, but they are still above the levels seen at many bear market lows. Higher interest rates would only increase the likelihood of lower P/E ratios, according to Hussman's last sentence, and that would mean a double whammy and lower stock prices. On the other hand, if interest rates fall substantially from here (TBond > 123, etc), that would imply deflation is coming and that the reflation attempts failed. That would scarcely be good news for P/E's or stocks either, but great for bonds.

In his letter of November 10, 2008 Hussman addresses these issues indirectly by showing the current version of his ten year projection of stock prices at various possible P/E ratios: http://www.hussmanfunds.com/wmc/wmc081110f.gif

If P/E's fall to 10 or below, as I imply above, annualized total returns for US stock indices could be only 4-6% even though stocks appear somewhat undervalued at this time. That would be even less than the annualized 8.6% returns for the S&P500 since 1988! But it would still be better than the returns or the past ten years of -1% per year.

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