In the spirit of hope and optimism for the New Year, I’m going to depart a bit from my usual concerns (which are no less pressing at the moment), and instead discuss when to become bullish, why to become bullish, and how often to become bullish. Using the word “bullish” three times in a single sentence may be a record for me. Despite being a lonely raging bull
for years coming out of the 1990 recession, and shifting positive in early 2003 after the 2000-2002 downturn, my defensiveness during the most recent cycle has lent far too much to my characterization as a “permabear.” Any previous bearishness I've had was validated by the 2000-2002 rout, and again by the 2007-2009 plunge, which wiped out the entire total return achieved by the S&P 500 - in excess of Treasury bill yields - all the way back to June 1995. While the S&P 500 - even with the recent advance - has underperformed Treasury bills for nearly 14 years, the stratospheric valuations of 2000 are well behind us. Valuations are still rich, but they are now in the range we've seen near more typical
bull market highs, so I also expect a more typical frequency of bullish opportunities in the market cycles ahead. Looking over the full span of history, the return/risk estimates from our ensemble methods have been positive about 65% of the time, and would indeed have encouraged a leveraged position (unhedged, plus a few percent in call options) about 50% of the time. Present conditions will change, and bullish opportunities will emerge, as they always have in other complete market cycles. Understandably, if one expects nothing but a defensive position at all times, even a moderate drawdown makes no sense to endure. But if one is pursuing a risk-managed strategy that seeks to take significant exposure over the course of the market cycle, and to significantly outperform the market over time, the drawdowns should be considered in the context of what the market itself typically experiences over the course of an ordinary cycle.
The average bear market loss is about 32%, and about 39% for cyclical bears that occur during secular bear markets. Given the extreme valuations that we’ve experienced since the late-1990’s, the two most recent market plunges in 2000-2002 and 2007-2009 took the S&P 500 down to less than half of the preceding bull market peaks. A 50% drawdown requires a doubling to break even. An 85% drawdown, as the market experienced during the Depression, is even more intolerable because one needs to more than triple just to get back to a 50% drawdown.
A quick note on my reputation as a "permabear." The most recent cycle required us to seriously contemplate Depression-era outcomes, and that presented us with significant challenges. I still believe it would have been reckless to ignore Depression-era data as irrelevant, and I also believe that investors invite ruin if they pursue approaches that are not robust to that data (or worse, restrict their attention to data that primarily includes the bubble period since the mid-1990’s). By the spring of 2012, we had addressed what I view as the two extraordinary features of the most recent market cycle – the need to contemplate Depression-era outcomes and incorporate the associated data into our methods, and the need to limit the use of actual put options in an environment where central banks have convinced investors that “virtual” monetary put options are free. While our valuation
estimates were actually constructive in early 2009, my larger stress-testing concerns kept us defensive until I was convinced that our approach was robust to Depression-era outcomes (stocks lost about two-thirds of their value in the Depression even after
historically normal valuations were established). The need to address that "two data sets problem
" was the "extraordinary" aspect of the recent cycle. Read the complete commentary