A note on evidence-based investment discipline: It will come as no surprise that we continue to encourage a patient, historically-informed strategy that aligns our investment stance with the estimated return/risk profile of the market at each point in time. A century of evidence demonstrates the effectiveness of this discipline both from the standpoint of return versus a passive investment approach, and from the standpoint of diminished risk. Yet this is also a discipline that has been decidedly wrong more recently. We have some explaining to do.Part of a good investment discipline is, and must be, to constantly seek improvements and address challenges. But part of a good investment discipline is also to recognize those points where discomfort is an unpleasant necessity. An “improvement” that might ease discomfort by reversing our presently defensive stance, but that would have left investors vulnerable to the deepest market losses on record, is no improvement at all. We tolerate the frustration of remaining defensive during this speculative advance because it shares hallmarks that were shortly followed by the most punishing market losses in history. The fact that a similar consequence has been deferred in this instance does not convince us that it has been avoided.It’s important to understand why we so adamantly adhere to our approach, having missed not only recent gains, but larger gains since 2009. The reason is simple: a significant portion of our miss in this cycle traces to what I view as a necessary stress-testing decision in 2009 that had the very unfortunate effect of foregoing returns that either our pre-2009 methods or our present methods could have captured. I’ll leave the fine points of this to prior commentaries of recent years, as I’m told that I make this distinction too often. I actually doubt that’s possible. The stakes of failing to understand this distinction are far too high – particularly now.As I’ve frequently noted, the most dangerous points to embrace risk are typically when a syndrome of overvalued, overbought, overbullish conditions emerges. In contrast, the most favorable points to embrace market risk typically occur when a moderate-to-severe retreat in valuations is followed by an early improvement in market action, as measured across a broad range of market internals (an opportunity that we easily accepted in early 2003 after the 2000-2002 bear market). The benefit of these considerations is straightforward to demonstrate in numerous complete market cycles across history, even using very simplistic factors – seeAligning Market Exposure with the Expected Return/Risk Profile.We can examine the recent market cycle (bull-peak to bull-peak since 2007) both from the standpoint of the methods that we successfully employed prior to 2009, and using our present methods – but excluding the awkward transition from one to the other. In both cases, the period from the 2007 market peak through about November 2008 is the segment would have been most responsible for strong performance relative to the S&P 500 over the complete cycle. In contrast, the period from about April 2012 would have clearly lagged the market regardless of method.The crucial segment affected by stress-testing in this market cycle was between those points. We successfully avoided much of the market’s collapse in 2007-2009, but the unfortunate outcome of stress-testing was to miss the opportunity in 2009 to respond to the combination of improved valuations and market action. In hindsight, we know that both our pre-2009 and present methods (which did not yet exist at that time, but were also not “trained” on that data) could have seized the opportunity. Unfortunately, it was unclear at the time whether the state-of-the-world was better characterized by post-war data (in which our existing methods had performed well) or in Depression-era data in which our existing methods allowed greater periodic losses than I viewed as tolerable. Had our avoidance of the market’s deep losses in 2008 simply been followed by that normal ability to embrace market risk in 2009 (on the coupling of a retreat in valuations with improved market action), I doubt that anyone would think twice about whether our present defensiveness is credible. The good thing, of course, is that we’ll never be faced with a similar stress-testing need again, as we’ve validated our approach against available data going back to the time when Ulysses S. Grant was President.In any event, I doubt that we’ll have much to lament by the completion of the current market cycle. We know the risks inherent in present market conditions, and we know how those risks are typically resolved (as they were after 1929, 1972, 1987, 2000 and 2007).As a side note, when we compare the two, most of the differences between the pre-2009 methods (which were based solely on post-war U.S. data) and the more robust methods (that resulted from stress-testing against Depression-era data) relate to the considerations that define that “early improvement” in market action. In Depression-era data, methods that worked just fine in the post-war period would have been ruthlessly whipsawed even if one relied heavily on trend-following features. Our present methods are more sensitive to measures of risk-premiums and default risk than the post-war methods were, require somewhat greater positive divergence as confirmation of “early improvement,” and include “ensemble” features that are also helpful across history. None of that, however, has encouraged us to embrace a set of persistently overvalued, overbought, overbullish, rising-yield market conditions more recently.
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