John Hussman: Why Make Money You Can't Keep?

by: John Hussman

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

The market’s late-2006 recovery did not reflect how the market has typically behaved under similar conditions of valuation and market action, but such deviations are to be expected from time to time. Every set of conditions we identify is associated with a range of outcomes – if there was no range, there would be no risk.

As usual, we don’t attempt to forecast which direction the market will move in each specific instance, but are concerned instead with the average return/risk profile that is associated with a given set of market conditions. So while the market’s late-2006 advance was not a typical outcome, it did not provide any compelling evidence that the market’s long term dynamics have changed. Over time, rich stock market valuations are strongly associated with unsatisfactory long-term returns. There is not a single instance in historical data since 1871 that 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.

When rich valuations are coupled with poor internal market action, or with extremely bullish investor sentiment, rising interest rates and overextended short-term trends, the market has generally underperformed Treasury bills, and has often experienced abrupt short-term losses as well. Such losses need not occur in every instance to justify heightened defenses in the face of those conditions...

The impact of bear market declines on compound returns is striking. It is useful to remember that, historically, less than half of the gains enjoyed during bull market advances are retained by investors by the end of the subsequent bear market. For example, a 30% bear market decline (about average by historical standards) would whittle an 80% bull market gain to just 26% over the full cycle...

As I inquired in a recent weekly comment, 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 record 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 the next inevitable correction by an amount that would make the net gains worth the risk?

My advice would be to patiently defend capital until conditions emerge that have historically produced acceptable returns, on average, given the risks involved. Those conditions will inevitably arrive, but they are currently not present.