John Hussman: Risk Is Highest When People Forget It Exists

by: John Hussman

Excerpt from fund manager John Hussman's weekly essay on the U.S. market:

One ought to become concerned about risk when investors become convinced that it does not exist. There are certainly times when it appears easy, in hindsight, to make money in the stock market. The difficulty is in keeping it through the full cycle. The fact that over half of most bull market advances are surrendered in the subsequent bear doesn't sink in until after the fact. It's all fun and games until someone gets hurt.

If the parents or the children of Wall Street analysts were to ask for wise investment advice, would the first thought of these analysts really be to encourage stock purchases at a multi-year market high, in a long-uncorrected and strenuously overbought advance, at a multiple of over 18 times earnings on unusually wide profit margins, with wages and unit labor costs rising faster than inflation, while interest rates are rising, bullish sentiment is unusually high, and corporate insiders are selling heavily? Would the potential for further gains in that environment exceed next inevitable correction by an amount that would make the net gains worth the risk? Would they encourage using trend-following systems in an overbought market, even though a decline to simple moving averages already implies substantial losses?

Uncorrected market advances give a voice to the idea that “this time it's different.” They invariably produce alternate valuation measures (like EBITDA multiples in the 90s, or price/forward operating earnings today) to replace the ones that suggest stocks are overvalued. These new-era arguments prevail despite the fact that the most recent evidence; the most recent market cycle; confirms the relationship between rich valuations and unsatisfactory long-term returns.

No. We've been here before, and the consequences – though not always immediate – have invariably been bad. There is not a single instance in historical data since 1871 when the S&P 500 traded above 18 times record earnings and there was not a low a year or more later that erased every bit of advantage over Treasury bills. Not one.

That's why despite the easy profits of the late 1990's, the S&P 500 has lagged risk-free Treasury bill returns since 1998. Despite the easy profits of recent months, the overall total return for the S&P 500 Index from July 24, 2000 through December 31, 2006 was just 9.46% (1.39% annually). The deepest drawdown in the S&P 500 over this period was more than -47%. During the same 2000-2006 period, the Strategic Growth Fund achieved an overall total return of 112.06% (12.38% annually). The deepest drawdown in the Fund during this period was less than -7%.

Simply put, there is no investment merit to the stock market at these valuations. The only reason to accept market risk might be speculative merit – the belief that stocks could be expected to outperform Treasury bills, on average, under prevailing conditions. That expectation would imply that some change in conditions would make a higher, likely, and acceptably profitable exit possible. Unfortunately, the present combination of overvalued, overbought, and overbullish conditions has produced average returns below Treasury yields. The evidence supporting a defensive position – at least temporarily – is already in hand. It's possible that we'll develop enough evidence to establish a more constructive investment position, particularly if a moderate decline can clear this overbought condition without a great deal of deterioration in market internals. Presently, however, we have no reliable basis for accepting market risk here...

A 10% decline in the S&P 500 would not even take the index to 1300. Are investors really willing to rule out that possibility?

SP Monthly 05 02 2007

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