John Hussman - Chumps, Champs and Bamboo
― Zig Ziglar
This story is more than a quote about persistence – it’s actually a reasonable description of risk-managed investing. Over the years, I’ve observed that numerous simple risk-managed investment strategies have substantially outperformed the market over the complete market cycle – particularly those that accept market risk in proportion to the estimated return/risk profile associated with prevailing conditions at each point in time. What I may not have done sufficiently is to describe the profile of how that outperformance is typically achieved over the market cycle.
As the workhorse here, let’s go back to the very simple model described in Aligning Market Exposure with the Expected Return/Risk Profile. What follows is not a description of the investment models we use in practice, which involve more numerous considerations and a much broader ensemble of models and methods. The measures presented here are very simple, and while even these conditions are associated with distinctly different average market outcomes, they’re nowhere close to the degree of separation that can be obtained and validated across history with a broader ensemble of evidence.
Without reviewing every detail, recall that this model partitions market conditions based on whether the S&P 500 is above or below its 39-week smoothing (MA39) and whether the Shiller P/E (S&P 500 divided by the 10-year average of inflation-adjusted earnings) is above or below 18. When MA39 is positive and the Shiller P/E is above 18, conditions are further partitioned based on whether or not advisory sentiment (based on Investors Intelligence figures) has featured more than 47% bulls and fewer than 27% bears during the most recent 4-week period. Investment exposure is set in proportion to the average return/risk profile associated with a given set of conditions (technically we use the “Sharpe ratio” – the expected market return in excess of T-bill yields, divided by the standard deviation of returns).
While a simple trend-following approach using MA39 alone (similar to following the 200-day moving average) has actually slightly underperformed the S&P 500 over time, that trend-following approach has had a fraction of the downside risk of a buy-and-hold strategy, with a maximum loss of about 25%, versus a maximum loss of 55% for a buy-and-hold. By contrast, the very simple Sharpe ratio strategy here has clearly outpaced a pure trend-following approach, with much smaller periodic drawdowns. Note that the chart below is on log-scale. Each horizontal bar represents a 100% difference in cumulative value.
While we view the illustrative model shown here as simplistic and merely adequate, it nicely demonstrates that investors benefit over the long-term by being conscious of trend-following considerations, valuation considerations, and the periodic emergence of overvalued, overbought, overbullish conditions.
To address the elephant in the room directly, I’ll note (as usual) that our own actual experience in 2009- 2010 differed significantly from this model as well as those we actually use in practice. This is because the unwise policy response to the credit crisis resulted in much deeper economic and employment losses than were ever observed in the post-war period, and I insisted on ensuring that we could navigate both post-war and out-of-sample Depression-era data (even though our existing methods had navigated the preceding years quite well). The resulting “miss” in the interim was not a reflection of models or strategy but rather what I saw as a fiduciary obligation.
I should also note that overvalued, overbought, overbullish conditions have been entirely ignored by the markets since late-2011. Those two events – one self-imposed, and the other what I view as a temporary deferral of bad consequences – have left a mark in the rear-view mirror. Still, the windshield is clear, and the key issue is how investors should approach the markets going forward. With no need for further stress-testing in future cycles, and every expectation that overvalued, overbought, overbullish syndromes will continue to bite as sharply as they have in every other complete market cycle, I continue to believe that the future belongs to disciplined investors who adhere to historically-informed strategies.
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