An Unacceptable (But Instructive) Model

John P. Hussman, Ph.D.
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I've frequently noted that investors need not take market risk at all times (or even a majority of the time) to capture the long-term return of the stock market. What is needed most is the avoidance of deep losses. It also helps to be willing to accept market exposure when valuations are depressed and other investors are bearish - particularly when yield pressures are falling. Indeed, there are numerous investment approaches that would have outperformed the market over time with less risk than a buy-and-hold strategy - the work is to find those that have good theoretical underpinnings and aren't just hindsight.

To advance that case without going into anything proprietary, here is a very simple (and definitely simplistic) model that I would never advocate using in practice, but I think it is instructive nonetheless. It substantially outperforms the market in historical data since 1965, and has sidestepped every major bear market, with a maximum drawdown of less than 15% at its worst point, compared with a maximum loss of nearly 50% for the S&P 500 (in the 73-74 bear, and again in 2000-2002).

The model goes long when the S&P 500 P/E is below 18 (based on the highest level of trailing net earnings to-date), the 10-year Treasury yield is below its level of 6 months earlier, and the Investors Intelligence figures show bearishness above 40% (measured as bears plus half of the "correction" camp). It sells on the reverse conditions, when the P/E is above 18, the 10-year Treasury yield is above its level of 6 months earlier, and bearishness is below 40%. It stays in its existing position until all three factors shift one way or another.

In my view, this is an unacceptable model for several reasons. First, it is a "timing" model - it is either in or out, on a "buy signal" or a "sell signal," which misses a great deal of potential returns that can be earned by varying market exposure in proportion to the return/risk profile of the market (which is what we do in practice). Second, it requires certain indicators to "ring a bell" and hit very specific "magic" levels. Such models are not very robust, in that the indicators can just miss such levels, and in the process, miss important moves altogether. While this model, for example, has sidestepped bear markets since 1965, there's no particular reason to believe that it won't miss a future one. A good investment model uses specific levels of an indicator only for fine-tuning - not to generate an all-or-nothing investment position.

Third, even with its reasonable long-term performance (though nothing exciting), the model has sat out of the market for most of the past decade. But this includes much of 2003, which was quite an acceptable period to take market exposure. The model outperforms the market since 1965, and it would have been invested well under 20% of the time since 1997 (outperforming the S&P 500 during this period as well). While much of that seems like a good thing, it also means that the model is too sensitive to specific conditions being met, and leaves far more on the table than it should. The model has to compensate for that by allowing the possibility of 100% exposure at relatively high P/Es near 18, while good models can be more selective at rich valuations while capturing a larger portion of returns at lower valuations. Overall, a good model may very well be defensive for long periods of time, but this one can be too conservative if its triggers aren't exactly met, and it creates far too much tracking risk relative to the major indices.

Despite its shortcomings, there are several reasons to present this model. First, it offers some insight into the considerations that separate a practical, useful investment model from one that simply looks good on paper. Second, it underscores the fact that an investor can sit out an enormous amount of time from the market and still capture all of its long-term return - provided the time spent out of the market is generally characterized by rich valuations, rising yield pressures, and high bullish sentiment, and that the investor generally does take exposure during periods of favorable valuations, falling yields, and high bearish sentiment.

In any event, moving to a defensive investment stance on rich valuations, rising interest rates, and high bullish sentiment has not historically resulted in missed long-term returns. To the contrary, the main outcomes an investor would have missed were the major bear market declines of the past half century.

Given current rich valuations, rising interest rates, and high bullish sentiment, all of this is clearly worth keeping in mind. Suffice it to say that I have no concern that our recent defensiveness will result in missed long-term returns. Though I have no strong opinions regarding short-term market direction here, I expect that the present speculation of investors will be quite poorly rewarded over time.

New From Bill Hester: Adjusting P/E Ratios for the Profit Cycle (additional link below)

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations, neutral (increasingly close to outright negative) market action, elevated bullish sentiment, and despite a very minor correction, still insufficient consolidation to "clear" the persistent overbought condition of the market in recent months.

The stock market has displayed a clear tendency to rebound sharply toward prior highs each time it corrects even modestly, and such a rebound shouldn't be ruled out in this instance. In that event, the market will continue to be characterized by the overvalued, overbought, overbullish syndrome that has held us to a defensive stance recently (such conditions are associated with stock returns below the Treasury bill yield, on average). On the other hand, unless the major indices decline here in combination with improved internals (breadth, leadership, price/volume action, industry strength, interest rate behavior, etc), even a modest amount of further weakness would be sufficient to put our measures of market action into a clearly unfavorable condition, thereby removing any motivation for us to take a modest speculative exposure to market risk.

In short, unless we observe an unlikely combination of behavior across market internals, my impression is that both a market advance and a market decline will leave us fully hedged in the coming weeks. The Strategic Growth Fund continues to have about 1% of assets allocated to a "staggered strike" position which provides somewhat greater downside protection at the cost of somewhat lower "implied interest" on our hedge. Our stock holdings have also quietly demonstrated strength relative to the market recently, as the preference of investors for "low quality" in the stock and debt markets appears to be waning.

It's too soon to conclude that investors' preferences have shifted from risk-seeking to risk-aversion, but as noted above, virtually any further market weakness will provide evidence of such a shift. At that point, it is quite possible that the floodgates may open with investors trying to simultaneously reduce their risk exposure. The question in such instances is whether there will be buyers on the other side at prices that are close to current ones. Given already high levels of bullish sentiment, there are few investors available to convert to the bullish camp, and my sense is that the holdouts (such as ourselves) are in no particular hurry to label stocks as "bargains" at prices anywhere in the current vicinity.

In bonds, the Market Climate last week was characterized by slightly unfavorable yield levels and unfavorable market action. Although 10-year Treasury yields have come down from their levels of a few weeks ago, that pullback is clearly within a well-defined upward "channel" of yield fluctuations. Meanwhile, credit spreads - though higher than they were several months ago - have not yet expanded enough to signal imminent recession risk, and oil prices have pushed back toward $70 a barrel. Although global security risks could induce some demand for currency as a safe haven (reducing monetary "velocity" and putting downward pressure on inflation), the overall set of investment conditions doesn't suggest any strong reason to take longer maturity exposures in the bond market. The Strategic Total Return Fund continues to carry a duration of about 2 years, mostly in TIPS, with a continued exposure to precious metals shares. Those shares briefly became oversold mid-last week before rebounding. At present, I view the group as reasonably valued and in a generally favorable Market Climate on our measures. The Strategic Total Return Fund paid an 18 cent quarterly income distribution on Friday.

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New From Bill Hester: Adjusting P/E Ratios for the Profit Cycle