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September 13, 2004

Time Inconsistency

John P. Hussman, Ph.D.
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Sometimes a little bit less discretion is a good thing. In Homer's The Odyssey, Ulysses instructs his crew to tie him to the mast of the ship to keep him from steering into the rocks to listen to the song of the Sirens. As the ship sails closer and the Sirens call out to him, Ulysses orders the crew (their ears plugged with wax) to untie him, but following his original orders, they bind him even more, and they escape the danger.

Economists use the term “time inconsistency” to describe situations where individuals constantly “reoptimize” over the short term, and quickly abandon the long-term plan that was originally optimal, in favor of some other plan that was originally recognized as inferior. Very often, a series of seemingly optimal short-term decisions will produce far less benefit than committing to a long-term plan, even though it constantly seems that a little “tweaking” would be nice. Procrastination, monetary policy, dieting, saving plans, and government deficits are all subject to time inconsistency problems.

This isn't simply a case of abandoning a long-term plan because new information arrives that makes the plan no longer desirable. Rather, the discretion to constantly “maximize utility” in the short run actually leaves the individual worse off in the long run.

Consider an oil cartel. If the cartel decides to hold the price of oil relatively high, it will make everybody in the cartel better off. But once the commitment to a high price is made, everybody has an incentive to cheat and produce more oil than they agreed upon in an effort to maximize their own revenues. Over time, everyone builds in an expectation that other members will cheat when they are determining their own behavior. Unless there is a way to credibly commit each member, the result is a much less desirable equilibrium for the whole cartel.

Time inconsistency is similar, but in this case, the cartel is between you and your future selves at various points in time. If you could bind all of your future selves to follow the plan, the whole group would be better off. But as time goes by, each of those individual selves tries to get a little more “privately” by cheating. Worse, once you all know that somebody's going to have an incentive to cheat, you'll follow a different long-term plan to begin with (usually with a suboptimal long-term outcome).

Time inconsistency is also a fact of life in investing. Though most investors recognize that following a disciplined, well-defined plan is essential to good results, the focus on short-term results and comfort is a constant enticement to deviate from good approaches. During the tech bubble, we saw many careful, conservative investors abandon solid, diversified, risk-controlled investment plans because the song of the Sirens seemed too beautiful. They justified aggressive weightings in technology shares by repeating “Sure, these might be volatile, but I'm a long-term investor.” Shortly afterward, they saw years of good saving and investing success smashed against the rocks. For many investors, a long-term investment plan consists of nothing more than an endless series of short-term speculations.

Comfort is expensive

In the investment markets, constant short-term comfort is extremely scarce. And because it is so scarce, you can count on it to be expensive if that's what you're after.

Investors who have had some experience with this fact generally find some way to commit to a particular investment plan. That sort of commitment is difficult because it requires investors to ignore constant enticements to deviate. The diehard commitment to a buy-and-hold strategy (espoused most clearly by Jack Bogle of the Vanguard Funds) is precisely a tool to help protect investors from themselves.

In general, buy-and-hold isn't a bad strategy, and is surely better than the strategy of constantly leaping from hot fund to hot fund on the basis of short-term performance. At present, however, buy-and-hold strikes me as a decidedly suboptimal solution to the time inconsistency problem. I emphatically believe that the S&P 500 is priced to deliver very disappointing long-term returns from current levels, for as long as 5-14 years. That view doesn't rely on unusual assumptions about future valuations or earnings growth rates, and doesn't even require the assumption that stocks will ever become significantly undervalued on historical benchmarks.

In any event, it's clear that constant short-term optimization and comfort-seeking is a very different objective than long-term optimization. Probably the closest you can get to pure short-term comfort-seeking in the financial markets is active trend-following – buy the rallies, sell the declines, buy the rallies again. It isn't any coincidence that especially in this year's market, investment systems that follow that sort of approach (e.g. managed futures) have been decimated by whipsaws in which rallies failed just after being bought, and declines reversed just after being sold.

As I've noted before, the key to success in virtually any pursuit is to define a set of daily actions that you believe will produce good results if you follow it consistently, and then follow it consistently. The best plans are built on careful theory and exhaustive testing. You focus on actions, and you're patient with outcomes.

Again, in my view, the strategy of simply buying-and-holding the market is, generally speaking, a reasonable long-term plan for many investors. It's certainly better than alternative plans that seek constant short-term comfort. My concern here is that stocks are not priced to deliver satisfactory long-term returns for buy-and-hold investors at these levels. Though no strategy can deliver constant short-term comfort, I believe that our discipline of varying our exposure to market risk – based on valuations and market action – is appropriate for investors whose objectives include long-term growth and risk-adjusted returns.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and tenuously favorable market action. Earnings for the S&P 500 have increased substantially over the past year, taking the reported figure on the index to just over $56, and resulting in a price/peak earnings multiple of about 20. That's the same level as the market reached at the 1929, 1972 and 1987 peaks, but we certainly saw a much higher peak in 2000 (near 34) before the subsequent plunge. Suffice it to say that valuations aren't cheap, and that even the considerations of interest rates and inflation are not sufficient to change that conclusion. Earnings for the S&P 500 remain well ensconced in their long-term peak-to-peak growth channel of 6% annually. On the basis of the price/peak earnings multiple, the historical average is about 14, and the historical median is 11.

If we look only at the top of that long-term earnings channel, we find that extending the 2000 earnings peak to the present at a 6% annual rate would produce a peak earnings figure close to $62, and a price/peak earnings multiple closer to 18. Still, if we argue that this is the level of “attainable earnings”, and is therefore the appropriate multiple to place on the S&P 500, we also have to go back and calculate historical norms based not on actual earnings or prior peak earnings, but on that same fundamental – top of channel attainable earnings. On that basis, the historical average multiple is only about 12, and the median is below 10.

Similarly, investors eager to look at operating earnings as the denominator for the P/E ratio should not compare that to the historical norm for price/trailing net earnings. As Cliff Asness of AQR Capital has noted, the proper historical norm for price/ operating earnings is closer to 12 as well.

So the relevant comparisons for earnings multiples here are price/peak earnings of 20 compared with a historical norm of 11-14, or price/ potential peak earnings of 18 compared with a historical norm of 10-12. Most of that history (in fact, nearly all of history before 1965) reflects interest and inflation rates similar to or lower than current levels.

Quick algebra – Assume that earnings were at their potential top-of-channel peak of $62 here, and were to grow along the top of that historical 6% peak-to-peak growth channel over the next 14 years. If the current price/ potential peak earnings multiple of 18 resolves simply to 15 ( well above the historical average and median for this extremely cheerful P/E measure), the resulting annual total return on the S&P 500 over the coming 14 years would still be just [1.06 (15/18)^(1/14) + .018(18/15 + 1)/2 = ] 6.61% annually. It's very hard to form expectations for stronger returns without making assumptions that depart completely from all historical experience.

Over the near term, the third quarter is coming to a close, which means that we'll start seeing many more earnings pre-announcements in the weeks ahead. Aside from the election, this is the most predictable time that we ought to see trading volume pick up and new “themes” developing. I continue to view the next several weeks as particularly important, and given both this relatively short horizon and unusually low option volatilities, I am very comfortable having “contingent” positions in the form of call options against our otherwise hedged investment position.

The Strategic Growth Fund remains fully invested in a widely diversified portfolio of individual stocks. While we do have a greater exposure to consumer and healthcare stocks from the standpoint of market capitalizations in the major indices, that exposure is far short of the representation of these groups in GDP (consumer spending and healthcare are also among the most stable classes of expenditure, and revenue stability is one of the best defenses against profit margin compression in a slowing economy). Despite fears that consumer spending will slow, it is an empirical fact that the vast majority of economic weakness is always traceable to gross domestic investment, so it does not follow that economic softness is likely to affect consumer stocks disproportionately. In other words, if consumer spending is set to slow, one should also expect more extreme slowdowns and profit margin compression in other industries.

Against our investment position is an offsetting short sale in the S&P 100 and Russell 2000 intended to remove the impact of market fluctuations from the portfolio. We also have a sufficient number of inexpensive call options (a fraction of 1% of assets) which would remove about 35% of the impact of this hedge in the event of a substantial market advance. In all, the Fund is best considered as modestly constructive, with the potential to automatically establish a somewhat greater exposure to market fluctuations in the event that the market advances further.

In bonds, the Market Climate continues to be characterized by modestly unfavorable valuations and market action. Despite the recent softening of oil prices and an accompanying pullback in the PPI, the potential for further economic weakness is largely offset by the potential for further core inflation pressures and U.S. dollar weakness. At present, our duration remains fairly modest at just 2.3 years, mostly in TIPS, with about 14% of assets in the Strategic Total Return Fund allocated to precious metals shares.


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