September 19, 2005
A few months ago, some economists at the Yale School of Management enlisted a group of capuchin monkeys in an experiment. They paired small metal disks with food until the monkeys learned to trade them with the researchers for bits of apple, grapes and jelly. By varying the monkeys' budgets and the amounts of food they would receive for a disk, the researchers found that the monkeys' behavior was within 1% of what could be predicted from economic theory.
The researchers then started randomizing the returns that the monkeys earned. As the London Economist reported*, the monkeys were allowed to choose between two “salesmen.” In the first experiment, “one salesman offered one piece of apple for a disk, while the other offered two. However, half the time the second salesman only handed over one piece. Despite this deception, the monkeys quickly worked out that the second salesman offered the better overall deal, and came to prefer him.”
“In the second trading regime, the salesman offering one piece of apple would, half the time, add a free bonus piece once the disk had been handed over. The salesman offering two pieces would, as in the first regime, actually hand over only one of them half the time. In this case, the average outcome was identical, but the monkeys quickly reversed their behavior from the first regime and came to prefer trading with the first salesman.”
Good investors do the same thing. As the Economist noted, “when faced with an exchange whose outcome is predictable only on average, most people prefer to avoid the risk of making a loss than to take the chance of making a gain in circumstances when the average expected outcome of the two actions would be the same.”
What's important, from our standpoint, is that the monkeys didn't try to predict which researcher would give them the better deal in each particular instance, but instead focused on average outcomes. Unless you actually have information that assists in making accurate predictions, and enough history to rely on that information, it's preferable to focus on the average return per unit of risk, even though you may not be correct in every instance.
In that sense, the monkeys' behavior is a lot like the optimal strategy in another game. Suppose I'm going to show you a series of cards and tell you that 80% will be green, and 20% will be red. You have to predict which one will come up next. If I actually draw the cards at random (or you learn through experience that you can't find information that helps to discern which card is next), the optimal strategy is not to randomly predict 80% green and 20% red. Instead, the best strategy is to predict green 100% of the time. You focus on the average outcome even though you know you'll occasionally be incorrect.
As investors, it's fortunate that there is, in fact, some information that helps us to know what the basic probabilities are. When we observe both favorable valuations and favorable market action (based on a wide variety of internals such as breadth, leadership, industry action, interest rates and so forth), we tend to see a lot of green cards. Not all the time, but enough to base an investment position on that average expectation. Importantly, red cards sometimes come up even in those generally favorable market conditions, but as long as we don't take positions that would result in unacceptable losses when a red card shows up, we can be comfortable.
Similarly, when we observe both unfavorable valuations and unfavorable market action, we tend to see a lot more red cards. Again, not all the time, but enough to base an investment position on that average expectation. Now, of course, if we could form even tighter expectations about likely returns using additional information, say, oil prices or budget deficits, it would make sense to use it. But unless it was possible to perfectly identify upcoming advances and declines, the best strategy would be to take the investment position having the best average return/risk profile, given the information available.
That's exactly what I try to do in my day-to-day management of the Hussman Funds. At present, valuations are elevated, market action is relatively neutral with a deteriorating bias, and a variety of additional considerations suggest the potential for a combination of inflation, economic weakness and credit defaults. That's not really an environment well suited to taking market risk in stocks and bonds. Still, even in this market environment, green cards will come up from time to time. At issue is whether we can expect them often enough, given our information, to risk the probable red cards. Right now, the answer in my opinion is no. There are certainly lots of things to do, provided that we diversify, hedge away or avoid those risks that don't seem likely to be rewarding. For example, we can focus on stocks with relatively stable revenues and profit margins, we can hold securities that tend to behave well as inflation hedges, and so forth, but at present, the Funds remain reasonably defensive in both the stock and bond markets.
As noted above, as of last week, the Market Climate in stocks was characterized by unusually unfavorable valuations and relatively neutral market action. In bonds, the Market Climate was characterized by moderately unfavorable valuations and now relatively neutral market action as well. In both cases, there is not a greatly compelling case for taking a substantial amount of market risk.
My impression is that the market's interpretation of inflation risks here, seen most clearly in the surge in gold prices, is basically correct. As I've long noted, inflation essentially reflects expansion in unproductive government spending. “Unproductive” in this sense doesn't refer to the social value of that spending, but the likelihood that it will add to productive capacity of the economy that did not previously exist and would not have existed if the funds were invested otherwise. If disasters were good for the economy, then we'd see a city rebuilt every year. Unfortunately, disasters cause economic disruptions, and rebuilding replaces rather than adds to productive capacity. Sure, some things will be rebuilt better than before, but those benefits are likely to be overwhelmed by the disruptions, not only in economic activity, shipping, and so forth, but in the natural resources markets. It's clear that some of the greatest demand impacts from Katrina will be on commodities such as lumber, oil and other real goods. In short, my impression is that the markets are correct and not nearly complete in responding to the inflationary potential of a government that promises hundreds of billions of dollars in real goods and services without the means to pay for them.
Shorter term, however, there is a great deal of potential for price whipsaws in the commodities markets (recall the scissors analogy from a few weeks ago). That applies not only to oil, but also to gold. As I typically do, I clipped off a modest portion of our precious metals position in the Strategic Total Return Fund on strength last week, essentially bringing it back toward 20% of assets after the appreciation in those shares. Still, we can expect a certain amount of day-to-day volatility in the Strategic Total Return Fund based on the day-to-day fluctuations in precious metals shares.
In Strategic Growth, the Fund remains largely hedged, with an exposure to market fluctuations ranging from between 5-15% of portfolio value, depending on day-to-day market conditions.
*Simian Economics - Monkey business-sense, The Economist, June 25, 2005
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