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Holly LaFon
Holly LaFon
Articles (7931) 

John Hussman: The Third Law of Randomness

July 18, 2012 | About:

On March 5th, our estimates of prospective return/risk conditions in the stock market fell to the most negative 2.5% of all historical observations (see Warning - A New Who's Who of Awful Times to Invest). On March 26th, those estimates fell to the most negative 0.5% of historical observations (see A False Sense of Security), and have remained in that range since that time. Market conditions have now been in this hostile set of conditions for 16 weeks. This situation might continue on to 20 weeks, or to 24 weeks. It might continue longer - though I doubt it. What we do know, however, is that when conditions have been similarly negative historically, the S&P 500 has plunged at an annualized rate of over 40%, distributed over some of the most awful outcomes in market history.

How do we know that the present instance will turn out similarly? We don't. Proper investing doesn't rule out randomness and unpredictability, particularly when it comes to individual events. It instead diversifies against randomness both across holdings at each point in time, and across time by repeatedly acting on the basis of averages instead of individual forecasts. Random events behave predictably in aggregate even if they're not predictable individually - a fact that Charles Seife calls the Third Law of Randomness. "To say something is random is not equivalent to saying that we can't understand it. Far from it. Randomness follows its own set of rules - rules that make the behavior of a random process understandable and predictable. These rules state that even though a single random event might be completely unpredictable, a collection of independent random events is extremely predictable - and the larger the number of events, the more predictable they become."

For us, what matters is the "conditional return" and the "conditional risk" - the average return, and the range of returns, that is associated with a specific set of market conditions. When the average return is highly negative, and the range of outcomes is narrow because those outcomes are almost invariably disastrous, you end up with a profoundly negative ratio of expected return to variability of return. This is where we stand.

In the meantime, our main risks are twofold. First, while our stock selections have historically outperformed the S&P 500 substantially over complete market cycles, there will be some periods in which those selections lag the S&P 500 and other indices we use to hedge. This is occasionally an inconvenience, but our stock selections are very deliberate, and we have a strong record on this aspect of our strategy.

Second, because of the extremely negative nature of present conditions, Strategic Growth Fund also has a "staggered strike" configuration that raises the strike prices of the long-put side of its hedges. Over the past two years, central banks have done their best to provide the equivalent of free put options to investors, which has reduced the benefit of paying for real ones. A few months ago, we responded by tightening our criteria for these positions, requiring not only strongly negative return/risk estimates, but also either negative trend-following measures or the presence of hostile indicator syndromes (Aunt Minnies). These criteria have the effect of reducing the historical frequency of these positions by more than half (and would have deferred our establishing these positions until March 5th of this year, when those hostile indicator syndromes became overwhelming). Many of the most damaging market losses in history fall into the set of instances that survive those criteria, as do market conditions at present.

At present, these hedge positions are both intentional and strategic. The risk here is that if the market does not decline significantly, the higher strike put options will incur time decay of a fraction of a percent per month while market conditions remain hostile (our estimated "theta" presently works out to about -0.3% monthly, which can vary depending on our choice of option strikes and maturities). Because these positions can also be expected to confer significant gains on extended market declines, they will also give up some of those gains in the event of subsequent advances if we don't have good opportunities to reset our strike prices. Again however, the outlay for these positions works out to a fraction of a percent per month in time value while conditions remain strongly negative.

Our investment strategy is intended to outperform our benchmarks over complete market cycles, with smaller periodic drawdowns. We pursue that objective by establishing investment positions that are roughly proportional to the expected return/risk profile that we estimate at any particular time. The peak-to-peak cycle from 2000 to 2007, and the trough-to-trough cycle from 2002 to 2009 provide instructive examples of how we pursue that strategy.

Over the most recent cycle from the 2007 peak to the recent 2012 peak, we succeeded in substantially limiting drawdowns, but Strategic Growth also lagged the total return of the S&P 500 by a cumulative amount of just under 13%. This was frustrating, but here is the point. If you understand the unusual nature of the most recent cycle, my decision in 2009 and early-2010 to make our methods robust to Depression-era data (and the "miss" that resulted as we addressed that "two data sets" problem), and the restrictions that we've placed on our defensive stances in order to better navigate periods of extraordinary monetary intervention, then you understand both the cause of our lag in the recent cycle, and the reason we don't anticipate such a lag in future cycles.

Again, the 2000-2007 peak-to-peak cycle and the 2002-2009 trough-to-trough cycle should reveal common characteristics of our approach, one which includes the tendency to be defensive during periods of exuberance when other investors are still drinking the Kool Aid. We avoided drinking it in 2000 because of bubble valuations, in 2007-2008 because of hostile market conditions and a probable credit-driven recession, and avoid it now because of clear evidence of unfolding global recession in the context of rich valuations, an army of negative indicator syndromes, and what are already largely unsolvable sovereign debt risks. From a historical perspective, present, observable market conditions give us no option but to be strongly defensive here.

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