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January 10, 2005

Fallacy of Composition

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

Atoms are practically weightless – a fact that doesn't help much when they're packed into the boulder falling off a cliff above your head.

The illusion that what is true for each member of a group must be true for the group as a whole is known as the “fallacy of composition.” It's an error that overlooks the interrelationships between the members. People make this sort of error all the time – when they try to run out of a crowded theatre, or when they believe that it's possible for them to get out of stocks quickly if things start looking bad.

As J.K Galbraith wrote in his 1955 book, The Great Crash: “Of all the mysteries of the stock exchange there is none so impenetrable as why there should be a buyer for everyone who seeks to sell. October 24, 1929 showed that what is mysterious is not inevitable. Often there were no buyers, and only after wide vertical declines could anyone be induced to bid… Repeatedly and in many issues there was a plethora of selling and no buyers at all.”

That's not to suggest that stocks are at quite the same risk today – yet. Valuations, as it happens, are even more extreme than they were in 1929, but the market to-date continues to display at least moderately favorable market action, indicating that for now, we don't have enough evidence to infer that investors have become dangerously skittish toward risk. Still, it's useful to remember that the best time to panic is generally before everybody else does. Or as Baron Rothschild once noted, “I made my fortune by selling too soon.” Fortunately, avoiding market risk at high valuations has never penalized long-term investment returns (see Risk Management is Generous).

The fallacy of composition has an opposite called the “fallacy of division.” The fallacy of division is the error of assuming that what holds true for a group must hold true for each of its individual members.

For example, it is unfortunate that, at least to my knowledge, it is not possible to forecast short-term movements in stocks, or to “time” the market – in the sense of identifying tops and bottoms with high precision or predicting short-term rallies and short-term declines. What is possible, in my view, is to identify market conditions that are associated with favorable or unfavorable return/risk characteristics on average, and to consistently align our investment stance with the average characteristics of the prevailing climate we observe.

Notice how important it is to avoid the fallacy of division here. To say that a particular market climate is generally favorable does not imply that the next movement in the market will be upward. Rather, it implies that on average, over a large number of instances in that climate, the market has historically generated a favorable return for the risk taken. Similarly, to say that a particular market climate is unfavorable does not imply that the next movement in the market will be down. Rather, it implies that on average, over a large number of instances in that climate, the market has historically generated an unsatisfactory return for the risk taken. It follows that short-term outcomes may have little relationship to the long-term average characteristics of those climates.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations but still modestly favorable market action. Despite what have historically been very dangerous valuations, market action has not demonstrated enough evidence that investors have abandoned their preference to take risk.

At current valuations it is already essential to have defenses in place: a modest amount of further deterioration in market action would be enough to shift the Market Climate for stocks to the most negative Climate we identify. That said, I added some very inexpensive call option positions in the Strategic Growth Fund on last week's market selloff to allow for potential market resilience given the still modestly favorable Market Climate.

Among the factors worth monitoring, the market produced a strong negative breadth reversal last week (a preponderance of declines over advances, closely following a preponderance of advances over declines). This heightens our alertness to watch for other breakdowns in market internals. Given that the major indices generally achieved new highs at the very end of 2004, it would be a particular concern if the number of stocks hitting new 52-week lows expands beyond the number of daily new highs in the sessions immediately ahead. Investment advisory bullishness remains at the highest level since 1987, while corporate insiders continue to liquidate stock at over 6 shares sold per share purchased (and far higher imbalances in terms of dollars sold and purchased).

With regard to the economy, a number of “toolbox” economic indicators have been deteriorating. For example, real liquidity growth (inflation-adjusted growth in aggregates such as the monetary base, M2, consumer credit and so forth) has dropped considerably and is now running near just 1% real growth year-over-year. That sort of deterioration is strongly associated with subsequent recessions, with a lag of anywhere from 0-8 months. Given that stocks typically turn down about 6 months before the economy does, the weakening liquidity growth is reason for heightened vigilance. Other indicators along the same line involve measures based on housing activity and employment growth. Though the headline numbers have been reasonable in these areas, we're seeing deteriorations in momentum that also tend to presage economic weakness. Finally, regardless of what one believes about the ascendance of online employment advertising, it is disturbing that the index of help wanted advertising has declined to just 36, matching the lowest level seen during or since the past recession.

As with the stock market, what we still don't observe is any important increase in investor aversion to risk. In general, recessions are preceded by a substantial – though sometimes abrupt – increase in risk spreads (the difference between risky corporate yields and safe Treasury yields). So even while we can identify clear fundamental imbalances, as well as initial deteriorations in internals and momentum both in stocks and in the economy, we won't entirely board up the windows and bolt the doors until we have evidence that investors have adopted a fresh skittishness toward risk. It can happen quickly, so we can't ignore the smoke believing that we can rush out of a crowded theatre once we actually see fire, but we still have to give the stock market and the economy some benefit of the doubt for now.

In bonds, the Market Climate for bonds is characterized by moderately unfavorable valuations and moderately unfavorable market action, which warranted a further cut in our already low duration in the Strategic Total Return Fund last week. At present, the Fund carries a duration of only about 2 years (meaning that a 100 basis point move in interest rates would be expected to impact the Fund by about 2% on account of bond price fluctuations). In addition, after reducing our precious metals positions a few weeks ago, the recent sell-off in gold shares has substantially improved the Market Climate for precious metals. As a result, the Fund's position in precious metals shares was increased toward 19% of assets last week.

Other remarks - Starfish theory

A final thought. The fallacy of composition also leads people to overlook their own ability to change the world – they pass up opportunities to help others, whether strangers in Thailand or Burma, or people in need nearby, because they believe that their contribution is too small to matter. It is easy to forget that we're made of the same substance as others, and that the way to create peace in the world is to create small elements of peace with our own lives.

There's a story of a father walking with his child on the beach. Every few steps, the father would reach down and pick up one of the starfish washed up along the shore, and toss it back into the water. After a while, the child asked, “Dad, there are thousands of starfish on this beach, what difference do you think you're going to make?” A few steps later the father tossed another starfish into the ocean. “For that one,” he said, “it makes all the difference in the world.”

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