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December 5, 2005

Forest from the Trees

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

Dependable profits are always the result of selling something that is both scarce and useful to others. One of the reasons that many investors have difficulty replicating the success of great investors like Warren Buffett is that many investors fail to even recognize the product that great investors sell.

To some degree, they profit by providing information to the market – buying overlooked values and selling overpriced speculations – but as Buffett wrote a long time ago, that information has been out since Graham and Dodd published Security Analysis, and “there are very few secrets in investing that are known only to the priesthood.” Mostly, what great investors sell to the market is patience, and the willingness to accept short-term discomfort by taking the opposite side of exactly those trades that speculative, impatient investors most desperately want to make.

Short-term market fluctuations create a sense of progress that stunts the long-term, analytical capacity of most investors, because they collapse returns that are desirable in the long run (say, around 10-12% annually) into very short windows of time. The result is that investors are tempted to ignore the big picture and instead attempt to chase and “game” short-term fluctuations. The fact that no great investor has done that successfully doesn't really factor into those attempts.

While my own willingness to selectively take or not take market risk may appear on the surface to be a timing attempt, the essential feature is that I make absolutely no effort to forecast short-term movements or figure out what the next direction of the market might be. The focus is squarely on identifying sets of market conditions (“Market Climates”) and aligning our investment position with the average profile of return and risk that has been characteristic of those Climates. In other words, the objective isn't to forecast the next “draw” out of the hat, but simply to identify which hat is in front of us.

While I always try to manage our risks in a way that we can accept outcomes that are occasionally completely at odds with the “average” behavior of the market in any given Climate, I don't reposition our investment stance in response to those short-term market fluctuations, so long as the new evidence fails to alter my interpretation of the prevailing Climate.

At present, I believe that it is essential for investors to focus on the forest rather than the (short term) trees. It's clear that investors are eager to rely on hopes for further year-end strength, as well as hopes of economic strength and earnings growth. But if you look carefully at earnings (aside from the fact that year-to-year earnings growth have a roughly zero correlation with year-to-year market returns), you'll notice some of the widest profit margins and the largest share of corporate profits as a percentage of GDP in decades. These measures are highly cyclical, and have a very poor record of persisting for long. Though corporate earnings can periodically surge at very high growth rates from an economic trough to an economic peak, the fact remains that measured peak-to-peak across economic cycles, S&P 500 earnings growth has been well contained at a 6% annual growth rate.

The chart below updates S&P 500 earnings (net trailing) as of the most recent data. Notice that the latest data point takes earnings right up to the peak of that 6% growth line, an event that has historically been associated with a) roughly zero growth in S&P 500 earnings over the following 5 years and b) on average, a price/earnings ratio for the S&P 500 of about 12 – the current multiple is 19.

Though I'd never recommend it as an investment strategy, and it's probably more interesting to long-term investors than short-term ones in any case, it turns out that historically, the strategy of simply selling the S&P 500 at a price/peak-earnings ratio of 19.5 and sitting out of the market until the multiple hit 15 (even if it took years and years in the interim to do so) would have outperformed a buy-and-hold strategy with substantially less drawdown. Think of it this way. A modest move from 19.5 to 15 times peak earnings sops up 4.5 years of 6% annual earnings growth along the peak of the channel. Again, it's definitely not a strategy I'd actually advise – it ignores the quality of market action, and involves far, far more tracking risk than most investors could tolerate – but it does emphasize the fact that stocks generally deliver very unsatisfactory long-term returns from high starting valuations.

In order to deliver a satisfactory long-term return from current valuations and the present position of earnings, we've got to observe continued growth along the peak of the channel, and also maintain high valuation multiples indefinitely. Not just for a year, or five years, but literally as long as the stocks are held. It's worthwhile to reiterate that even if S&P 500 earnings grow along the top of the channel over the next decade and the market's multiple simply touches 16 over that period (still well above the historical average multiple on both record earnings and raw trailing earnings), the total return on the S&P 500 for the coming 10 years will only be 6.17% annually. That's a disappointing return to get from such optimistic assumptions.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and still unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance. Despite seasonal hopes and economic optimism, the overall constellation of market conditions currently provides no support for accepting a material exposure to market fluctuations here. That may change if, for example, internals improve enough to signal a robust preference of investors to take risk, but here and now, risk-taking seems confined to speculative sectors of the market. The recent strength in the indices is mostly a reflection of financials, high beta groups like technology, and very recently, oil shares. In any event, the prevailing Market Climate remains clearly unfavorable here, but that doesn't imply any forecast of what conditions might prevail even a week or two from now. As usual, we'll take our evidence as it comes.

In bonds, the Market Climate remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Total Return Fund to a relatively short 2-year portfolio duration, mostly in Treasury inflation protected securities, with a continue exposure to precious metals shares representing somewhat less than 20% of portfolio value here.

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New from Bill Hester: Average Gain in Year Two of Presidential Cycle Hides Important Declines

 


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