Despite my reputation in recent years as a “permabear,” I’ve actually had quite a variable relationship with equity risk across three decades in the financial markets, and that relationship has always depended on market and economic conditions. It’s difficult to judge stocks as “good” or “bad” investments without reference to valuations and other factors. For example, after the 1990 bear market, I had a reputation as a “lonely raging bull” and advocated a leveraged stance in equities for years, based on a combination of reasonable valuation and strong market internals. While investors worried about weak consumer confidence, I frequently noted that weak confidence is correlated with strong subsequent market returns. It’s the combination of high confidence, lopsided bullishness, overvaluation and overbought multi-year advances that opens a chasm into which the market ultimately plunges. History is remarkably consistent on this point, and it requires discipline to avoid that damage. Reducing exposure to risk in these conditions is the first pillar of full-cycle investing.
Accordingly, I was no fun at all by the 2000 market peak. It was impossible to justify equity valuations except on assumptions that were wholly outside of historical experience. We keep a talking Pets.com sock puppet in the office as a reminder of that bubble. A little squeeze and he says things like “Hey, you’re a good-lookin’ fella. I like your shorts.” By the time the 2000-2002 decline partially unwound the bubble, the S&P 500 had lagged Treasury bills all the way back to May 1996.
As I’ve often observed, the best time to accept market risk is when a material retreat in valuations is coupled with an early improvement in market action across a range of market internals, industry groups and security types. On that basis (and even though valuations were still rich from a historical perspective), we removed the majority of our hedges in early 2003 as a new bull market took off. I actually got complaints as some investors thought I had somehow abandoned our discipline. Please understand this now so that you are not surprised later: shifting to a constructive or leveraged position following a material retreat in valuations, coupled with an early improvement in market action, is part of our discipline. Accepting exposure to market risk in these conditions is the second pillar of full-cycle investing.
Not surprisingly, the combination of high confidence, lopsided bullishness, overvaluation and an overbought multi-year advance made me again no fun at all by the 2007 peak. The narrative of what followed was the same – by the time the market bottomed in early 2009, the decline had wiped out the entire total return of the S&P 500 – in excess of Treasury bills – all the way back to June 1995.
It’s at that point that I made the decision that sent my reputation to hell, at least for the advancing portion of the current cycle. As economic and financial losses during the crisis stopped resembling anything observed in post-war data and began to resemble Depression-era outcomes much more closely, I insisted on stress-testing our methods against that data. Our existing methods of classifying market return/risk profiles (which were based on post-war evidence) did well in that Depression-era data overall, but experienced more whipsaws and far deeper interim losses than I was willing to contemplate in real-time.
In hindsight, the main outcome of those stress-tests was that more demanding variants of what we call “early improvement in market action” were needed to navigate Depression era outcomes. The trouble with hindsight, of course, is that we identified that distinction too late to benefit from it. Our post-war measures of market action had encouraged us to respond constructively in late-October 2008 after the market plunged (as I observed at the time, on a material retreat in valuations coupled with early improvement in market action – see Why Warren Buffett is Right and Why Nobody Cares). The stress-tested ensemble methods that ultimately resulted would have deferred that response to early-2009. But in the interim of that “two data sets” uncertainty and stress-testing, we entirely missed the 2009-2010 opportunity to do what we have done in past market cycles and expect to do in every future market cycle, which is to shift to a constructive or leveraged position following a material retreat in valuations, coupled with an early improvement in market action.
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