John Hussman: Plunging Equity Valuations Should Impact Stock/Bond Allocation

Includes: DIA, QQQ, SPY
by: John Hussman

Excerpt from the Hussman Funds' Weekly Market Comment (1/5/09):

While stock prices are now moderately undervalued, and are priced to deliver reasonably good returns over the coming decade (regardless of shorter-term prospects), Treasury bond prices are currently buoyed by such a “flight to safety” that they have ironically become speculative investments themselves... The long-term Treasury market now requires near-depression economic conditions to justify prevailing prices and yields-to-maturity. In the event that the general level of risk aversion among investors eases, either the U.S. Treasury market or the value of the U.S. dollar will endure disproportionately large losses...

With the recent surge in Treasury bond prices, the effective duration of a 30-year Treasury bond has climbed from just over 16 years to nearly 20 years. Meanwhile, the plunge in the stock market has collapsed the duration of the S&P 500 from nearly 60 years to just about 30 today. For investors who rebalance their portfolios annually, this is essential information. Given the probable long-term returns that stocks and Treasury bonds are priced to deliver, an investor seeking a 7% long-term total return would currently require an allocation of about 60% in stocks and 17% in bonds, for an overall portfolio duration of about 21 years – only a third of the duration that an investor seeking that same long-term return would have had to accept just 15 months ago!...

Investors are sometimes urged to allocate a percentage of assets to stocks equal to 100 minus their age. In my view, this formula is terribly crude, because it ignores the impact of valuation on the duration of stocks... Given current valuations, the appropriate allocation – again for a passive investor with a 20-year horizon – could be as high as 58% in stocks, provided that the remainder of the portfolio is in fairly short-duration, low-volatility securities.