July 21, 2014
Optimism vs. Arithmetic
Current market conditions provide an ideal moment to highlight the distinction between investment and speculation. Sound investment is a) the purchase of an expected stream of future cash flows that will be delivered to the investor over time, where b) the price paid today will result in an acceptable long-term return if those expected cash flows are delivered, and c) the expectations are set using assumptions that allow a reasonable margin of safety. As Benjamin Graham observed long ago, “Operations for profit should not be based on optimism but on arithmetic.”
Speculation, by contrast, is the purchase of a security in the expectation that its price will increase. Speculation relies much less on calculation than on psychology, particularly of two forms: a) expected changes in sponsorship, and b) expected changes in risk aversion.
Sponsorship essentially reflects a gradual increase in the eagerness of other individuals to participate in an advance (or in the case of a panic decline, to avoid further losses). Note that this does not necessarily require an increase in the number of participants holding the security, since the stock that is purchased by a buyer must – except in the case of new offerings – be supplied by an existing holder who sells. A speculative advance rides on the wave of increasing eagerness of others to hold the security, who in turn expect even further price increases and even greater eagerness by others. The pool of potential sponsors is very deep when bearish sentiment is very heavy and bullish opinion is scarce. The pool of potential sponsors begins to tap out at the point that bullish sentiment becomes very lopsided compared with bearish sentiment, especially for an extended period of time.
Changes in risk aversion can also feed speculative waves. Recall that for any given set of expected future cash flows, a higher price today implies a lower future rate of return on that investment. When investors are very risk averse, prices drop today and expected future rates of return increase, in order to compensate investors who continue to hold the security. Conversely, when investors become very risk-seeking (as they have in recent years based on the belief that central banks have the ability to prevent any negative event), prices advance today and expected future rates of return are compressed, leaving no compensation for potential risks down the road. The prospect for a significant reduction in risk aversion is strongest when prices are deeply depressed and concerns about risk are widespread. The prospect for a further reduction in risk aversion is slim when prices are at multi-year highs and risk spreads are already extremely compressed.
At present, we observe clearly negative investment prospects for the equity market. Moreover, bullish advisory sentiment (Investors Intelligence) has now surged past 60%, compared with only 15% bears, while risk premiums have declined to record lows on junk debt, corporate debt, and equities (equally-weighted) – and to near-record lows on capitalization-weighted equity indices. While trend-based measures are generally positive here, providing some speculative basis for purely trend-following strategies, the fact is that these strategies have typically not fared well, on average, in similarly overvalued, overbought, overbullish conditions, even when interest rates have been quite low. The persistence of these overextended conditions in the present speculative episode has undoubtedly been a source of frustration for us – and we’ve adapted by being less aggressive in our response. Still, we would have to contravene a century of historic evidence, as well as valuation methods that have not missed a beat even in recent decades, in order to embrace equity market risk in present conditions.
Last week’s comment, Ockham’s Razor and the Market Cycle reviews the arithmetic relating to present stock market valuations, and what it means for investors. A century of evidence provides every reason to expect zero total returns on the S&P 500 at horizons of 8 years or less, and only about 1.8% annually over the coming decade. The implications are worse for measures that take the position of profit margins into consideration (which the most historically reliable measures do). I should emphasize that while these measures provided accurate warning at the 2000 and 2007 peaks, they were also quite positive at the 2009 lows, projecting 10-year S&P 500 total returns in the 12-14% annual range, depending on which measure one used (see also our late-October 2008 comment, Why Warren Buffett is Right and Why Nobody Cares).
I’ll note again that our own challenges in the recent market cycle related first to my insistence on stress-testing against Depression era data even though we got the credit crisis quite right, and later, to the unusual persistence of extremely overvalued, overbought, overbullish conditions that have remained uncorrected longer than has historically been the case (see Setting the Record Straight and This Time is Different, Yet with the Same Ending for a review of that narrative, and the adaptations that resulted). It’s quite possible that these conditions will remain uncorrected even longer, and a reliance on that possibility may provide some support to the speculative case. But it’s important not to confuse this speculation with sound investment. Market participants are not investing at current valuations. They are gambling at a point where the untapped pool of potential sponsors and the room for further contraction in risk premiums have become quite limited.
Do interest rates matter? Sure. The rate of return on safe investments can certainly affect the rate of return that investors are willing to accept. Still, we can determine their impact with basic arithmetic – there's no need to guess. As an example, suppose that a “normal” long-term return on U.S. equities is 10%, a “normal” yield on 10-year bonds is 6% (we’ll assume zero-coupons for simplicity), and a “normal” yield on safe Treasury bills is 4%. If interest rates on Treasury bills were expected to be held at zero for a 5-year period, with normal yields thereafter, it would be competitive for stocks and bonds to be priced to achieve commensurately lower returns in the initial 5-year period as well. This means raising prices accordingly. If you do the arithmetic, you’ll find that the “fair” price of stocks and bonds in this case would be roughly 20% higher than you would calculate otherwise (e.g. for bonds 100/(1.02)^5*(1.06)^5 = 67.68, versus 100/(1.06)^10 = 55.84). Importantly, while one could say that “fair value” was higher, those higher prices would still be associated with lower long-term returns than otherwise.
Put another way, if one expects a 5-year period of zero Treasury bill yields ahead (compared with a norm of say 4%) one can reasonably justify an increase in price of about 20% (5x4%) in stocks and longer-term bonds, which would also imply a “fair” reduction of about 2% in the 10-year annual return of those instruments. What one cannot say, however, is that since stocks and bonds would be “fairly valued” at those elevated prices, they should provide historically normal returns going forward.
Accordingly, if investors believe that it is “fair” for stocks to be priced to enjoy zero total returns for the next 8 years, we are perfectly happy to say that stocks are at “fair value” under that assumption. But it still follows that stocks should be expected to achieve zero returns for the next 8 years. Similarly, if investors believe that it is “fair” for stocks to be priced to achieve total returns averaging 7.5% over the coming 50 years, we are perfectly happy to say that stocks are at “fair value” under that assumption. But it still follows that stocks should be expected to achieve 7.5% total returns over the coming 50 years from current levels. Furthermore – and this is something that is constantly overlooked by investors who wish to amortize rich valuations over very, very long periods of time – if at some point, say 10 years from today, stocks are even briefly priced to achieve historically normal 10% long-term total returns, it still follows that the S&P 500 will be lower than current levels a decade from now.
In other words, one can certainly argue that stocks should be priced for decades and decades of lower long-term returns than they have historically enjoyed. But along with that assumption, one must rely on stock valuations never touching historical norms (much less secular troughs) in the interim in order to avoid quite a long period of zero or negative returns from current levels. I’ll reiterate that while secular bear market lows do not occur frequently, they do tend to average about 50% of typical valuation norms (compared with current valuations, which are about 210% of the historical norm, using an average of numerous historically reliable measures). The resulting arithmetic is quite simple: even if stocks were to touch a secular low even 24 years from today, and even if fundamentals such as nominal GDP, corporate revenues, and corporate earnings match their long-term peak-to-peak growth rate of 6% annually between now and then, the S&P 500 would actually be below its current level 24 years from now [Calculation: (1.06^24)*(0.5/2.10) = 0.96].
To repeat Benjamin Graham, possibly before it is too late for investors with horizons shorter than 8-25 years: “Operations for profit should not be based on optimism but on arithmetic.”
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.
The Hussman Funds remain defensive toward equities and Treasury securities, and constructive toward precious metals shares. In Strategic Growth, we continue to allow room for the market to run by being quite slow to raise the strike prices of the index put side of our hedges. As such, much of the day-to-day fluctuation in the Fund will be related to differences in performance between our stock holdings and the indices we use to hedge, at least until the market declines by several percent from present levels. Our return/risk estimates remain quite negative, but we understand the desire to limit the drag from put option decay, while at the same time adhering to our discipline of aligning our investment stance with the market return/risk profile that we estimate based on current conditions.
I continue to have every expectation that we will have opportunities to substantially or entirely remove our hedges, possibly sooner than investors may expect, and most likely at a point that joins a material retreat in valuations with an early improvement in market action. There is no need for that event to occur anywhere near historically “normal” valuations. Despite a major decline in the stock market from the 2000 peak, valuations were still quite elevated in early 2003 when we removed the majority of our hedges near the beginning of the subsequent bull market. While our move to reduce hedges after the market plunged in late-2008 was later complicated by my insistence on stress-testing our methods against Depression-era outcomes, our valuation measures were below historical norms at the time. Our stress-testing miss was not related to valuation measures, and provides no basis at all to ignore our valuation concerns at present. Moreover, I believe that our measures of “early improvement in market action” are far more robust as a result, and I don’t expect any further stress-testing concerns to interfere in future cycles.
Despite the challenges of the recent half-cycle, we very much view HSGFX as a growth fund, albeit with a much greater ability to deviate from a passive investment stance than other funds. Our experience prior to the half-cycle since 2009 was uncomplicated by stress-testing concerns and other features that we’ve adapted to in recent years, and may better illustrate the basis for that view. Unless diagonally advancing and uncorrected markets are now the permanent rule (which I don’t believe for a second), I expect the full range of investment opportunities from aggressive to defensive as the present cycle completes and those ahead unfold, even if the median valuation level of the market will be forever higher than in the past (which again, I don’t believe, but have no need to rule out either).
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