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Strategic Allocation (White Paper)

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John P. Hussman, Ph.D.
President, Hussman Investment Trust

August 2019


On Friday, July 27, 2019, based on the prevailing level of stock market valuations and interest rates, our estimate of likely 12-year average annual total returns for a conventional, passive investment portfolio (invested 60% in the S&P 500 Index, 30% in Treasury bonds, and 10% in Treasury bills) fell to 0.46% – the lowest level in U.S. history except for single week of the 1929 market peak.

– John P. Hussman, Ph.D., July 29, 2019

The set of opportunities available to investors is constantly changing. It changes every time stock market valuations change, every time interest rates change, and even when the psychology of investors shifts from speculation toward risk-aversion, or back again.

The same thing happens with risk. When investors are inclined to speculate (which we infer from the uniformity or divergence of market action across thousands of securities), extreme market valuations may be followed by even greater extremes. When investor psychology shifts toward risk-aversion, extreme valuations can result in steep market losses, and even depressed market valuations may not be enough to prevent further declines.

How can investors align their asset allocation across stocks, bonds, and money market securities to respond to these changing opportunities and risks?

Valuations, interest rates, and expected returns

Across a century of market cycles, valuations in stocks and bonds have been strongly related to subsequent long-term investment returns and full-cycle market risks. With over three decades of work in this area, one of the most frequent questions I hear is “How do you factor interest rates into your stock market valuation measures?”

The fascinating thing about that question is that it reflects a quiet misunderstanding of valuation – one that is regularly encouraged by Wall Street. It’s an aphorism on Wall Street that “low interest rates justify high stock market valuations,” as if those high market valuations can then be expected to be followed by historically normal stock market returns. That’s not the way investment valuation works.

See, an investment security is basically a claim on a stream of future cash flows that investors expect to be delivered into their hands over time. If you know the expected cash flows and the expected return you require, you can calculate the current price that would produce that expected return with nothing but a calculator.

For example, if a zero-coupon bond promises to deliver a single $100 payment in 10 years, and you are willing to pay a price that would generate a 6% expected annual return, it’s simple math that the associated price today should be $100/(1.06)^10 = $55.84.

Likewise, if you know the expected cash flow and the current price, you can calculate the expected return that’s implied by that price. In this case, ($100/$55.84)^(1/10)-1 = 6%.

Notice something. The relationship between valuation and expected return is just math. Given the stream of cash flows expected from the security, you don’t need to know anything about the level of interest rates in order to map the valuation of that security into the associated expected return. There is clearly some uncertainty involved in estimating those future cash flows, and there is also risk that they will not arrive as expected. Still, given a reasonable estimate of those cash flows, along with the observed price, the expected return can be estimated directly.

Now, if you don’t actually know the current price, you might look to interest rates in order to decide what expected investment return is acceptable, and it’s certainly true that the lower the expected return you are willing to accept, the higher the price you might be willing to pay. But fundamentally, to say “I am paying a high valuation for this security, because interest rates are low” is equivalent to saying “I am willing to accept a low expected return on this security, because other available returns are also low.”

In a world where valuations can be directly observed, and where expected future returns can be estimated, the question “How do you factor interest rates into your valuation measures” is actually the wrong question. Across three decades of market cycles, I’ve found it to be universally true that investors ask that question most frequently during speculative episodes – as a way of excusing extreme stock market valuations – not as a way to gain useful information that might help their asset-allocation decisions.

Asking the right questions

In my view, here are some of the questions that are essential to a long-term asset allocation strategy:

    • How can we take prevailing stock market valuations, long-term interest rates, and short-term yields jointly into account, so that our estimates of expected return and risk for each can be directly compared and incorporated into our investment decisions?
    • If our investment goal is to provide for a long-term stream of future inflation-adjusted spending, how can we systematically allocate our assets in a way that reflects both near-term and long-term investment prospects?
    • What does it mean that interest rates are near record lows, while the stock market valuation measures we find best-correlated with subsequent market returns are at speculative extremes?
    • How can we systematically respond to the ongoing shifts in expected return and risk that emerge over the course of the market cycle, including the unusual opportunities and risks produced by market collapses, speculative bubbles, unexpected economic events, and extraordinary monetary policy?
    • How can we allow for periods when investors become so eager to speculate, or so averse to risk, that valuations temporarily don’t matter at all, and historical “limits” to speculation or risk-aversion fail to hold?
    • How can we reduce the risk of exiting too soon from an overvalued but still-advancing market, and reduce the risk of prematurely building investment exposure to an undervalued but still-collapsing market?
    • Can a flexible, value-focused investment strategy provide an alternative, or at least diversification, to a passive fixed-allocation portfolio? Can it be applied as effectively in periods of depressed valuations (e.g. 1974, 1982, 1990, 2009) as periods of elevated market valuations (e.g. 2000, 2007, 2018), and provide an alternative even in a world where investors have come to believe that “there is no alternative” other than speculation?

Strategic Allocation

Strategic Allocation is a systematic asset allocation strategy created to address these questions. Our new white paper, Strategic Allocation describes this approach.

It’s a maxim in the financial markets that past returns look most glorious, and extreme valuations look most irrelevant, exactly at the point where future investment prospects are the weakest. Given the extraordinarily low prospective returns that we currently estimate for a conventional, passive investment mix (e.g. 60% S&P 500, 30% Treasury bonds, 10% Treasury-bills), I believe it’s very important for investors to have a disciplined alternative to a fixed-allocation strategy.

The set of opportunities available to investors is constantly changing. It changes every time stock market valuations change, every time interest rates change, and even when the psychology of investors shifts from speculation toward risk-aversion, or back again.

The goal of the Strategic Allocation approach is to provide for the ongoing, long-term, inflation-adjusted spending needs of investors. The investment strategy combines:

1) A value-focused asset allocation component that:

      • Jointly considers prevailing stock market valuations together with the level of interest rates;
      • Assigns a portion of the portfolio to the asset class estimated to have the highest average annual expected return, adjusted for risk, between today and each future year of a long-term horizon;
      • Combines these annual allocations so that the overall allocation to stocks, bonds, and Treasury bills reflects the share of total present value allotted to each of these preferred asset classes.

2) A risk-management component that:

      • Adjusts investment exposure during segments of the market cycle where pressures toward risk-aversion or speculation may temporarily drive valuations outside of their typical range.
      • Reduces the risk of overly aggressive investment allocations when market action is uniformly negative (conveying that investors are inclined toward risk-aversion), as well as the risk of overly defensive investment allocations when market action is uniformly positive (conveying that investors are inclined toward speculation).

This approach can be applied in a wide variety of actual market conditions observed in decades of prior market cycles, including typical market conditions as well as speculative bubbles and financial market collapses, helping to create asset allocations that are responsive to prevailing valuations and investment opportunities.

Strategic Allocation represents a disciplined, value-conscious, historically-informed, risk-managed, full-cycle approach to long-term investment, capable of responding to changes in market conditions in a way that target-date and fixed allocation strategies do not.

In my view, aligning asset allocations with the valuations that drive long-term returns, while adjusting exposure to allow for shorter-term risk-aversion or speculation among market participants, is a systematic way to respond to the ever-changing landscape of investment risk and opportunity.

Investing involves risk, and there is no assurance that any investment strategy or method of analysis will remain effective in future market cycles. The Strategic Allocation white paper is intended to illustrate the general framework of this approach but should not be interpreted as an exhaustive account of the considerations or market analysis techniques used to determine the investment positions of any of the Hussman Funds. Information relating to the investment strategy of each of the Hussman Funds is described in its Prospectus and Statement of Additional Information.

Click this link, or the graphic below, to read Strategic Allocation

Strategic Allocation paper frontpage

 

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