John Hussman: Risk Management and Convex Return Profiles

Excerpt from the Hussman Funds' Weekly Market Comment (11/2/09):

This week, I want to continue the analysis of “convexity,” and its implications for how we should approach uncertainty in what seems likely to remain a very tenuous investment environment.

We continue to face two data sets here, which characterize two very different possibilities for the true state of the world. One possibility, which is clearly the one that Wall Street has subscribed to, is that the recent downturn was a standard, if somewhat more severe than normal, post-war recession; that the market's recent strength is an indication that it is looking forward to a full “V-shaped” recovery, and that the positive print for third-quarter GDP is a signal that the recession is officially over. Applying the post-war norms for stock market performance following the end of a recession, the implications are for further market strength and the elongation of the recent advance into a multi-year bull market.

The alternate possibility, which is the one that I personally subscribe to, is that the recent downturn was the initial phase of a more prolonged deleveraging cycle; that the advance we've observed in recent months most likely represents mean-reversion – qualitatively and quantitatively similar to the large and often abruptly terminated “clearing rallies” of past post-crash markets; that major credit losses are continuing quietly but are going unreported thanks to changes in accounting rules by the FASB this past spring, which allowed for “substantial discretion” in accounting for loan losses and deterioration in the value of securitized mortgages; that a huge second-wave of mortgage losses can be expected from a reset schedule on Alt-A and Option-ARMs that has just started (following a lull in the reset schedule since March) and will continue into 2010 and 2011; that intrinsic economic activity remains abysmal; that recent GDP growth is an artifact of massive fiscal stimulus that is unlikely to have sustained follow-through; and that recent market valuations are not representative of those observed at the end of most post-war recessions, but are instead similar to those observed at major market peaks prior to the mid-1990's.

Our primary challenge here has been to reasonably integrate these two possibilities. As I noted last week, one possibility is to weight the data itself and treat the resulting average as if it were a single data set. However, by evaluating our investment approach on the assumption of each possible state of the world, and then weighting the resulting investment positions, we can obtain some benefit from "model diversification," which reduces our reliance on a single view or expectation being correct.

Comments

[John Galt:]

It boggles my mind how anybody would think that this was just an average recession and that things will just go back to the way they were in a year or so.

If you want to argue inflation/deflation, the markets value, or what the government should/shouldn't do then fine. There are smart people on both sides of those debates.

but to say that this was just a another recession and that things will "resume" is foolish.

Nov 02 01:23 PM

[Analyste de...:]

Hussman is BRILLIANT, but he jumped in waaay too early last Fall. Pity he didn't follow his own logic & calls (I thought I did!) with more certainty. My Portfolio ended up +15% for 2008.

His Growth Fund (HSGFX) got badly burned, and he turned conservative at the most inopportune time! For 12 Months, his fund is DOWN -16%, while the S&P500 (SPY) is UP +8%. (My Model is UP +71%, and clients are gladly cycling some gains into PM bullion.)

Now Hussman is hedging his bets on the 'purported' rally... or answering performance concerns of investors? Hard to tell, but catch-up is wicked painful!

Nov 02 07:26 PM

[The Geoffster:]

Anyone not paying attention to public and private debt is living in an alternative universe. Insolvency pervades the economy. Adding liquidity is throwing good money after bad. Off balance sheet liabilities will be realized as soon as the FED has to jack up rates. The mother of all liabilities is waiting to explode as the bulk of the boomers retire and start collecting social security, require bypass surgery and break their hips. Anyone under 50 will see their lifestyles drastically diminished and their future entitlements cut . The question is whether the FED will monetize the debt and permit hyperinflation or allow interest rates to reach equilibrium.

Nov 02 09:27 PM

[GordonG:]

Deseret News, The (Salt Lake City, UT) - June 12, 1994

NEWSLETTER SAYS STOCKS ARE A BEAR

Hussman Econometrics (34119 W. Twelve Mile Road, Farmington Hills, Mich. 48331), which The Hulbert Financial Digest has called ``the most promising newcomer among investment newsletters'' after its first three-year performance doubled the market's return, has turned bearish on stocks. ``The market is beginning to display the classic traits generally associated with bull-market tops. The time to buy stocks is in the middle of a recession, not when an expansion...

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A Coupla Bears Tell Why They're Still Growling
Pay-Per-View - Los Angeles Times - ProQuest Archiver - Mar 3, 1995
It's not the end of civilization, Hussman says: "Stocks are just due for a natural, normal, run-of-the-mill bear market." ...

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Analyst unimpressed by Pyxis rival
Pay-Per-View - San Diego Union - Tribune - ProQuest Archiver - Jul 30, 1995
John P. Hussman of the Michigan-based newsletter Hussman Econometrics is not bullish on the stock market now,

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BusinessWeek: May 15, 1995
Adds John P. Hussman, a money manager and investment newsletter writer based in Farmington Hills, Mich.: "There's a likelihood of slipping into a bear market at any time."

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S&P'S 500 DIVIDEND YIELD IS 2.66%, LOWEST OF CENTURY
$2.95 - Deseret News - NewsBank - Jun 18, 1995
``The stock market has left itself no room for error,'' observes Hussman Econometrics (34119 W. Twelve Mile Road, Farmington Hills, MI 48331). ...

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May 5, 1996

STOCKS OFFER LOW-RISK PREMIUM, PAPER SAYS
The latest argument for higher stock prices is that Baby Boomers are saving more and investing it in stocks, notes Hussman Econometrics (34405 W. Twelve Mile Road, Farmington Hills, Mich. 48334). ``In fact, there's been no evidence of any significant increase in the U.S. savings rate. The money-flow argument ignores the fact that every buyer's dollar that enters the market leaves it moments later with a seller. Stocks currently offer the lowest risk-premium in...

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Published on March 26, 1996, The Washington Times{PUBLICATION2}

Market's total value points to bad times

There have been five times this century when the size of the stock market (total capitalization) relative to the size of the economy (nominal gross domestic product) exceeded 75 percent, as it does today, observes Hussman Econometrics (34119 W. Twelve Mile Road, Farmington Hills, Mich. 48331)

"Each instance coincided with a Standard & Poor's 500 dividend yield of only 3 percent or less, as is also the case now. Each marked the peak of a major bull market

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Mr. Bear and Mr. Bull
By Mark Hulbert, 02.10.97
Forbes

The bear is John Hussman, editor of Hussman Econometrics, and adjunct professor of economics at the University of Michigan. What sets Hussman apart from the other bears isn't his focus on the market's fundamental extreme overvaluation. That's something he shares with virtually every other bear. What makes Hussman's bearishness noteworthy is his compelling explanation of the mistakes he made several years ago when he and the others turned prematurely bearish. ;

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Published on July 1, 1997, The Washington Times{PUBLICATION2}

Sky-high prices may warn of stocks' fall

Historically, when the price-earnings ratio on the Standard & Poor's 500 has been above 20-to-1, as it has been recently, it has always been because earnings are depressed, observes Hussman Econometrics (34405 W. Twelve Mile Road, Farmington Hills, Mich. 48334).

"This is the first time in history that we've seen a P/E over 20-to-1 on record earnings. The only two times the P/E exceeded even 19-to-1 on record earnings was in 1964 and 1972. In

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Published on June 3, 1997, The Washington Times{PUBLICATION2}

As dividend yields sink, how far can stocks rise?

"The extremely high returns on stocks over the past 14 years have been the result of a decline from the highest dividend yield in two generations, 6.7 percent in August 1982, to the lowest dividend yield in history, now well below 2 percent," notes Hussman Econometrics (34405 W. Twelve Mile Road, Farmington Hills, Mich. 48334).

"It seems unlikely that the dividend yield can fall much from current levels. So it seems equally unlikely that stocks can rise

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Nov 7, 1997

Stocks have never been this highly valued when earnings were at record levels, notes Hussman Econometrics (34405 W. Twelve Mile Road, Farmington Hills, ...

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Economist: U.S. might already be in recession

The San Diego Union - Tribune - San Diego, Calif.
Author: DON BAUDER
Date: Oct 30, 1998

He's John P. Hussman of Sunrise, Fla.-based Hussman Econometric Advisors, and he says the markets are already giving off clear recessionary signals: The interest rate spread between corporate debt and Treasury debt has widened, indicating growing fear of credit risk, while the spread between long- and short-term Treasury instrument interest rates has narrowed considerably, suggesting the market expects a very sharp growth slowdown.

Combine these so-called "forward-looking" indicators with other similar ones, such as the stock market decline, the drop in consumer confidence and the National Association of Purchasing Managers Index suggesting that manufacturing is contracting, and "the signal says, `Hey, we're expecting very slow growth, probably recession,'" Hussman says.

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Nov 03 07:38 AM

[Analyste de...:]

Dear GordonG,
Thanks for "doing our homework" and showing how wrong Hussman has been as a perma-bear for 15 years.

I emphatically agreed with his rationales (the ones I read, from 2002 on) on the fundamentals, but I DISAGREED on how to invest until the RE mkt began collapsing. Investors truly focused on fundamentals were punished until the Great Bear - they may be punished more, for awhile, for their prudence & discipline.

Sad to admit, but true!

On Nov 03 07:38 AM GordonG wrote:

> Deseret News, The (Salt Lake City, UT) - June 12, 1994
>
> NEWSLETTER SAYS STOCKS ARE A BEAR
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Nov 21 01:43 PM