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February 21, 2006

Very Nicely Swept!

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

I took my first skiing trip when I was 11 years old, at a point in life when hitting an ice patch and plowing snow down a mountainside with my face seemed like a blast. At 43, not so much. Spent the long weekend about 100 miles north of Montreal, where good friends, cross country skiing, and tubing down the slopes were great fun. Good returns at reasonably low risk – a fine combination for me. I don't terribly miss my old skiing, surfing, and hang-gliding attempts. My willingness to take low-payoff risks may be broken, but at least it's not a bone.

The winter Olympics also have a range of risks. Ski jumps are probably at the higher end of the risk spectrum, while the lowest risk event almost has to be “curling.” Curling is a sport that looks to the novice observer almost exactly like shuffleboard. An athlete pushes a large flat-bottomed “marble” down a lane toward a bulls-eye, but with a twist – two additional teammates skate down the lane alongside the marble, furiously scrubbing the ice with little broomsticks, apparently trying to subtly alter its direction and range. These efforts are rewarded by the remarks of on-air sports commentators, using phrases like “Oh! Very nicely swept.”

Watching the curling competition, it struck me that the strategy for winning is not at all apparent to the casual observer. There is some sort of specific skill required as the marble moves down the lane, and some “sub-game” being played, that makes the difference between winning and losing.

The same is true of investing. To the casual observer, investing seems to be about finding the next Microsoft or Google (assuming that Google doesn't suddenly find itself looking like the tech-wrecks of several years ago, which I suspect is a poor assumption). The apparent skill seems to be finding the next great growth story, getting an inside line on future earnings prospects, or timing the next market move.

In truth, to my knowledge, skills like that are both unreliable and unnecessary for investment success. They require success to be far, far too specific. Instead, effective long-term investing requires the “averages” to work out well – not only the average performance of the stocks in a diversified portfolio, but also the average performance of the portfolio over a series of investment horizons.

The key skill required for good investing, in my view, is the willingness to abandon the specific in favor of the average. That means abandoning the attempt to find one or two “special” and unique stocks, and instead applying a careful stock-selection discipline in order to create a whole portfolio with certain “average” characteristics of valuation, market action, financial strength, and so forth. It also means abandoning the attempt to forecast the market's direction over some specific period ahead, and instead aligning the investment position with the “average” return/risk profile that stocks have experienced when historical market conditions have matched prevailing ones.

So winning depends on a specific skill that might not be immediately obvious. That skill is the willingness to focus on average outcomes, and to ignore specific ones. It's a quality that's commonly called “patience,” and it's rewarding precisely because it is rare.

As Joel Greenblatt, a successful value-oriented hedge fund manager writes, “How can our strategy keep working after everyone knows about it? Well, here's some really good news. As it turns out, there are plenty of times when [value investing] doesn't work at all! Isn't that great? In fact, on average, in five months out of each year, the portfolio does worse than the overall market. But forget months. Often, it doesn't work for a full year or even more! That's even better! … If a strategy works in the long run (meaning it sometimes takes three, four or even five years to show its stuff), most people won't stick with it.”

In “The Little Book that Beats the Market,” Greenblatt makes a subtle reference to (most probably) Jim O'Schaughnessy, writer of “What Works on Wall Street,” who emphatically advocated patient investment discipline:

“Take, for example, the case of the author with a best-selling investment book. For his book, the author tested dozens of stock-picking formulas over a period of many decades to determine which of those strategies had beaten the market over the long run. The book was excellent and well-reasoned. The author then opened a mutual fund based on buying only those stocks picked by the most successful formula of the dozens he had tested.

“The fund then proceeded to perform worse than the major market averages for two of its first three years. For one of those years, the fund underperformed the market average by 25 percent! After three years, the fund was performing poorly relative to competing funds and the best-selling author – the guy who did the tests, the guy who wrote the book – decided to sell his fund management company to somebody else! … Had he known that the same fund, the one managed strictly according to his formula, would come back over the next three years to be one of the top-performing mutual funds since the time of its inception (even including the tough first few years), perhaps he would have stuck with it longer!”

The point is simple. In investing, there are subtle skills – discipline and patience – that make all the difference between winning and losing. Casual observers of investing seem to believe that the required skill is the ability to find the next “hot” stock, or to forecast earnings surprises, or to “time” the next advance or decline in the market. Not so – the required skill is precisely to abandon the “specific” – that is, the attempt to pick individual “winners” and predict short-term market outcomes – and to focus instead on the “average.”

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and relatively neutral market action. There continue to be enough cross-currents to prevent the overall expected return to market risk from being compelling, but our investment exposure will change if the evidence improves. At present, the best evidence supporting additional exposure to market risk would be a pullback in the major averages without much deterioration in market breadth (advances versus declines), leadership (new highs versus new lows) and other measures.

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 duration, with a substantial portion of total assets in Treasury Inflation Protected notes.

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