Investors Respond to Fear, not Risk

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

The Nobel economist Gary Becker has argued that people don't respond to risk - they respond to fear. The probability of a bad event might be extremely small, but if the thought of it provokes a lot of fear, people will alter their behavior anyway. Likewise, the risk of a bad event might be substantial, but if there is no fear, people will fail to alter their behavior, sometimes with catastrophic results. Unfortunately, what provokes fear in the markets is a decline already in progress. So rather than reducing their exposure as soon as risks have measurably increased, they try to reduce their exposure when a market decline is already a fait accompli.

A few weeks ago, the stock market entered a Market Climate that I associate with very real, measurable, and actionable risk, so I moved the Strategic Growth Fund to a fully hedged investment stance. The market is characterized by the combination of unusually unfavorable valuations, a clearly unfavorable quality of market action as measured by a wide variety of internals, and rising interest rate trends backed by inflation pressures. Only about 4% of historical periods fall in this bucket, but they contain the preludes to nearly every notable market crash on record. That's not to say the Market will crash, or can be expected to crash, any more than having a stack of newspapers next to a hot stove means that the house will go up in flames. It's just that the average outcome is not good at all.

I don't talk like this often. In fact, I've been frustrated to watch various investors speculating in short sales and put options and the like over the past couple of years, when valuations have been unfavorable but market action has still been favorable in my opinion. Historically speaking, conditions that would warrant even being neutral toward the market only happen about one-quarter of the time (though more often in recent years because of rich valuations). Conditions that would warrant using short sales and put options in a speculative way (not just to hedge existing market risk) occur even less, and require at least the combination of both unfavorable valuations and unfavorable market action. There have literally been only a few weeks since March 2003 when put options and short sales have been reasonable speculations (again, hedging aside). It's been painful to see certain investors burning through their capital in the attempt to gain from the short side of the market over the past couple of years while the Market Climate has been constructive (if you think I'm referring to you, then yes, I might be referring to you).

At present, we do have what I view as a clearly unfavorable Market Climate. I still don't advocate short positions or speculative bearish positions, and the Strategic Growth Fund's most defensive position is "neutral" to market fluctuations. Still, I want to point out the risk clearly here because it might matter to somebody's financial security. If you have an investment position where your financial security would be unacceptably harmed if the S&P 500 was to fall by, say, 30% over a 16-24 month period, then you're taking an investment position that carries unacceptable risk, in my view. At present, the Strategic Growth Fund, being fully hedged against the impact of market fluctuations (with our long-put/short-call index option combinations having identical strike prices and expirations), and is not expected to sustain much impact even if stocks experience a very strong market decline. We could, however, experience positive or negative returns based on the difference in performance between the stocks we hold and the indices we use to hedge (mainly the S&P 500 and the Russell 2000 indices). Historically, that difference in performance has contributed substantially to the returns of the Fund, but especially over short periods of time, the difference can go either way.

In any event, it should be clear here that I am concerned that shareholders not take, in their other investments, so much stock market risk that their financial security would be seriously impaired by substantial weakness in the stock market. That sort of weakness isn't a forecast, and it is always possible that subsequent market action will "clear" a lot of the negatives that we are currently observing in the internal structure of the market. But here and now, there's no compelling historical basis in my analysis for taking substantial stock market risk.

Becker points out that it's fear that most people respond to, not risk. At present we see very little fear, and that's my concern. Barron's latest "Big Money Poll" (which I sparsely answered because it asked questions like "where do you see the Dow, S&P and Nasdaq at the end of '05?) shows an increase in bullishness of about 10% since spring, with 47% bulls and 28% bears. Meanwhile, the S&P 500 has been in a wide trading range since January 2004, and is presently only about 3% above its levels at that time. So for the better part of two years, investors have become accustomed to buying intermediate selloffs and lightening up on intermediate rallies. With stocks having declined in recent weeks, the market seems to have great resemblance to other intermediate lows over the past couple of years, which proved to be nice buying points, hence a tendency toward more bullishness here.

Again, it's not out of the question that this instance could be one also, but unlike most of the market action we've seen over the past two years, the current decline is marked by a very clear deterioration in the quality of market action, which makes it measurably different in character from those previous intermediate term lows. A simpler way to say this is that in those other instances, the intermediate term bottoms turned out to be reliable. In this instance, there's a chance that the bottom could "drop out" so that what looks like the "support" of an oversold market condition actually turns out to be only a short resting point.

But what if the market really is at a short term bottom? Aren't we taking a lot of risk of missed gains by holding to a fully hedged, relatively neutral market stance? Well, it's certainly true that if the market rebounds strongly, we'll miss out on the first few percent of the new upmove. But if in fact the market is to advance by a meaningful amount, its tendency would be to recruit favorable quality in market action fairly quickly (improved breadth, leadership in the form of stocks achieving new highs, expanding trading volume on rallies, healthier industry performance, and so on). It's on that evidence that we would shift our investment stance to a more constructive position. For now, the burden of proof is on the market to exhibit some set of characteristics that would warrant an exposure to market fluctuations.

Again, I don't talk like this often, but I think it's better to take the risk of a certain amount of missed gains than for investors to have positions that would unacceptably harm their financial security in the event of substantial market weakness. We're now in a Market Climate where that kind of market weakness, though still not an "expectation" or a reliable "forecast," is well within the range of plausible outcomes.

Market Climate

As noted above, the Market Climate for stocks last week was characterized by unusually unfavorable valuations, unfavorable market action, and rising interest rates backed by inflation pressures. It's historically not a good environment for accepting substantial risk of market fluctuations, so the Strategic Growth Fund is fully hedged. Enough said.

In bonds, the Market Climate remained characterized by modestly unfavorable valuations and unfavorable market action. A substantial widening of credit spreads would help the case for accepting longer bond-market durations, because it would imply greater probability of oncoming economic weakness. For now, the Strategic Total Return Fund holds to a portfolio duration of about 2 years (a 100 basis point move in interest rates would be expected to affect the Fund by about 2% on the basis of bond price fluctuations).