In June, we completed a very challenging transition in our methods of classifying market return/risk profiles. That transition started with my 2009 insistence on stress-testing our methods against Depression-era data, resulted in ensemble methods that were stronger across history than our pre-2009 methods, but failed to sufficiently capture certain bubble-tolerant features of those methods, and was completed when we adapted by imposing variants of those features as a set of overlays – largely relating to market internals, credit spreads, and other factors that I’ve often referred to as “trend uniformity.”
You can see the effect of those overlays in the June 16, 2014 comment Formula for Market Extremes, with additional detail on this transition in Setting the Record Straight and Hard Won Lessons and The Bird in the Hand.
If one wishes to share what we’ve learned from our experience, without dispensing of the benefits that we’ve demonstrated from this historically-informed, value-conscious, risk-managed discipline in prior cycles, the key lesson is this: The near-term outcome of speculative, overvalued markets is conditional on investor preferences toward risk-seeking or risk-aversion, and those preferences can be largely inferred fromobservable market internals and credit spreads. The difference between an overvalued market that becomes more overvalued, and an overvalued market that crashes, has little to do with the level of valuation and everything to do with investor risk preferences. Yet long-term investment outcomes remain chiefly defined by those valuations.
I expect our experience in the future to be far more like our experience prior to 2009 than during the challenging transition that began with that 2009 stress-testing decision. I can’t offer assurances about the future, but I can offer assurance that we’ve completed this adaptation in a way that’s robust to every market cycle we’ve observed across history, including Depression-era data, post-war data, and the period since 2009. My confidence about the future is based on that robustness, irrespective of whether the market will collapse or continue to advance for years to come. I expect we’ll be able to navigate both.
Learning the right lesson
An unfortunate aspect of our awkward learning curve since 2009 is that it has emboldened many observers to use our experience as “proof” that market risk is always worth taking and that historically reliable measures of valuation have become ineffective, to be disregarded or replaced with some more benign alternative. The primary thrust of my weekly comments since June (when, in my view, we completed our awkward transition and put it behind us) has been to clarify the correct lesson to draw from our experience. Walk through this with me. I realize that this is repetitive for those who have been with me for a long time, but I promise you - it’s worth getting this lesson right. The coherent framework I’ve described – focusing on both the level of risk premiums (inferred from valuation) and the risk preferences of investors (inferred from observable market internals and credit spreads) is robust to market cycles, inflation, deflation, growth, recession, depression, easing, tightening, greed, exuberance, fear, panic, bubbles, and crashes across a century of history.
With valuations extreme, credit spreads behaving badly and market internals still quite divergent, it’s absolutely essential for investors to understand that the current environment differs importantly from the bulk of the period since 2009. See, through most of this period, with key exceptions of mid-2010, mid-2011 and today, credit spreads have been well-behaved and market internals have been generally favorable. Overvalued, overbought, overbullish conditions that historically were followed by steep losses simply became more extended and severe, which was a persistent source of frustration for us. In hindsight, if one thing has been truly “different” about the half-cycle since 2009, it’s that the speculative yield-seeking provoked by quantitative easing has created much less overlap between periods of overvalued, overbought, overbullish syndromes and periods of deteriorating market internals and credit spreads. Historically, both features tended to emerge relatively close together. Not in recent years. But importantly, when they have – even since 2009 – the market has lost significant value during those periods on average. I’ll show you a bit of that in a minute. First, I want to reinforce the key lesson I’ve been emphasizing in recent months.
“When risk premiums are historically compressed and showing early signs of normalizing even moderately, a great deal of downside damage is likely to follow. Some of it will be on virtually no news at all, because that normalization is baked in the cake, and is independent of interest rates. All that’s required is for investors to begin to remember that risky securities actually involve risk. In that environment, selling begets selling.”
- Low and Expanding Risk Premiums are the Root of Abrupt Market Losses, August 11, 2014
“The effect of valuations on subsequent market returns is conditional. While depressed valuations are a good indication of strong prospective long-term returns, depressed valuations don’t prevent further – sometimes massive – losses in the near-term. A retreat in valuation becomes reliably favorable mainly when it is joined with an early improvement in market internals. All of history (not just the Depression-era and the 2008-2009 collapse) imposes demanding requirements; not least that internals aren’t collapsing and credit spreads aren’t shooting higher, as they are today. Conversely, overvalued, overbought, overbullish extremes are associated with total market returns below risk-free interest rates, on average, but that average features an unpleasant skew: most of the week-to-week returns are actually positive, but the average is harmed by large, abrupt losses. Such extremes become reliably dangerous when they are joined by deterioration in market internals.”
- Air Pockets, Free-Falls and Crashes, October 13, 2014
“Our most important lessons in the half-cycle since 2009 are not that overvaluation and overextended syndromes can be safely ignored. Historically, we know that these conditions are associated with disappointing subsequent market returns, on average, across history. Rather, the most important lessons center on the criteria that distinguish when these concerns may be temporarily ignored by investors from points when they matter with a vengeance. In other words, our lessons center on criteria that partition a bucket of historical conditions that are negative on average into two parts: one subset that is fairly inoffensive, and another subset that is downright brutal. Central to those criteria are factors such as deterioration in the uniformity of market internals, widening credit spreads, and other measures of growing risk aversion. Once that shift occurs, market declines often bear little proportion to whatever news item investors might latch onto in order to explain the losses.”
- On the Tendency of Large Market Losses to Occur in Succession, October 20, 2014
continue reading: http://www.hussmanfunds.com/wmc/wmc150112.htm
