Excerpt from the Hussman Funds' Weekly Market Comment (11/18/2013):
“The seed of a bamboo tree is planted, fertilized and watered. Nothing happens for the first year. There´s no sign of growth. Not even a hint. The same thing happens – or doesn´t happen – the second year. And then the third year. The tree is carefully watered and fertilized each year, but nothing shows. No growth. No anything. Then the bamboo tree suddenly sprouts and grows thirty feet in three months.”
― Zig Ziglar
This story is more than a quote about persistence – it’s actually a reasonable description of risk-managed investing. Over the years, I’ve observed that numerous simple risk-managed investment strategies have substantially outperformed the market over the complete market cycle – particularly those that accept market risk in proportion to the estimated return/risk profile associated with prevailing conditions at each point in time. What I may not have done sufficiently is to describe the profile of how that outperformance is typically achieved over the market cycle.
As the workhorse here, let’s go back to the very simple model described in Aligning Market Exposure with the Expected Return/Risk Profile. What follows is not a description of the investment models we use in practice, which involve more numerous considerations and a much broader ensemble of models and methods. The measures presented here are very simple, and while even these conditions are associated with distinctly different average market outcomes, they’re nowhere close to the degree of separation that can be obtained and validated across history with a broader ensemble of evidence.
Without reviewing every detail, recall that this model partitions market conditions based on whether the S&P 500 is above or below its 39-week smoothing (MA39) and whether the Shiller P/E (S&P 500 divided by the 10-year average of inflation-adjusted earnings) is above or below 18. When MA39 is positive and the Shiller P/E is above 18, conditions are further partitioned based on whether or not advisory sentiment (based on Investors Intelligence figures) has featured more than 47% bulls and fewer than 27% bears during the most recent 4-week period. Investment exposure is set in proportion to the average return/risk profile associated with a given set of conditions (technically we use the “Sharpe ratio” – the expected market return in excess of T-bill yields, divided by the standard deviation of returns).
Part of the ability to sustain discipline comes from understanding the profile of returns from that discipline over time. For example, investors often become convinced late in a bull market that “the greatest risk is being out of the market.” The only antidote to that is an understanding of how critical those speculative moments are from the standpoint of full-cycle investment returns. Put simply, the majority of the outperformance from risk-managed investment approaches over time comes from the avoidance of severe initial losses following overvalued, overbought, overbullish conditions, and from the limitation of deep and extended losses as market action subsequently deteriorates.
Though the market has advanced in the face of persistently overvalued, overbought, overbullish conditions since about late-2011, the result is a financial precipice that has become even more extreme and hazardous.
To illustrate how the long-term outperformance of risk-managed strategies often accrues over the full course of the market cycle, I’ve divided the graph above into a number of segments spanning complete market cycles (measured trough to trough; measuring peak-to-peak would just shift these by a half-cycle). Again, I’ll emphasize that the model we’re using for illustration is quite simplistic – enough to adequately demonstrate the point, but nowhere near what a broader ensemble of considerations can achieve over the complete cycle.
Consider first the two complete market cycles from the 1957 bear market low to the 1966 bear market low. While a simple risk-managed approach outperforms the S&P 500 over both complete cycles, with far smaller periodic losses, the long-term outperformance is owed to the repeated avoidance of severe losses.
Note the 1961 and 1965 market peaks, where a buy-and-hold was clearly ahead for a while. It’s difficult to overstate my view that present market conditions largely recapitulate these instances. At bull market peaks, it often seems that the market is simply headed higher with no end in sight, and “buy-and-hold” appears superior to every alternative. Meanwhile, the reputation of value-conscious investors and risk-managers goes from “champ” to “chump.” Then, the bamboo tree suddenly sprouts, and the entire lag is often replaced by outperformance in less than a year. Only after the fact does the reputation of risk-managed strategies surge from “chump” to “champ.” By then, it’s unfortunately too late to be of help to many investors who capitulated in frustration at the peak.
There’s a great deal to be learned from actually examining historical evidence and thinking carefully through how securities are priced. For example, we know that valuation measures that adjust for the cyclicality of profit margins have always and invariably been more tightly related to subsequent market returns than those that don’t. We know that bond yields and stock yields were negatively correlated prior to 1970, and have also been negatively correlated since about 1998.
It’s important to think carefully about how cash flows are discounted and securities are priced. For example, we know that the benchmark 10-year Treasury bond has a duration of only 8.8 years, while the S&P 500 has a duration of about 50 years (mathematically, one can show that the duration of equities is inverse to the dividend yield). So while low 10-year Treasury yields may strongly impact the discounting at the front end of that duration, one can’t use the 10-year yield as a one-to-one valuation benchmark for equities unless one is convinced that inflation will be low and the economy will still be weak beyond 8.8 years from now, in which case one’s nominal growth assumptions collapse.
Stock valuations are far less sensitive to 10-year Treasury yields than Wall Street seems to believe. It turns out that the presumed one-to-one relationship between the 10-year Treasury yield and equity yields (specifically the “forward operating earnings” yield) is nothing more than an artifact of a 16-year disinflationary period between 1982 and 1998, when bond yields declined diagonally and a secular bull market in stocks gradually morphed into a valuation bubble. Outside of that span, the tight relationship between stock yields and bond yields assumed by “Fed Model” has a laughably dismal record, and yet Wall Street and Janet Yellen appear to reference it as fact because they are evidently too convinced by the rules-of-thumb in their heads to actually examine the data (see the August 2007 piece Long Term Evidence on the Fed Model and Forward Operating P/E Ratios for a trip down memory lane, as I tried to disabuse the same beliefs at that market peak. Spoiler alert - nobody listened, and the market plunged by 55%).
The bottom line here is that THE ANSWERS ARE IN THE DATA. Empirical questions about valuations and profit margins and wealth effects can be answered, often quite precisely. The empirical conclusion, unfortunately, is that investors are likely to pay dearly for the inattention to evidence that has enabled the present equity bubble.