We Learn From History That We Do Not Learn From History

John P. Hussman, Ph.D.
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“We learn from history that we do not learn from history.”

Georg Wilhelm Friedrich Hegel

Last week, Investors Intelligence reported that bullish sentiment surged above 60%, coupled with a 5-year high in the S&P 500 and valuations beyond 18 times record trailing earnings. The same combination was last seen the week of the October 2007 market peak, last seen before that in January and May 1999 (which we should emphasize was good for only a 5% correction in the short run before a choppy run to the 2000 peak, but would still leave the S&P 500 more than 40% lower three years later), last seen before that the week of the August 1987 pre-crash peak, and last seen before that in January 1973, just before the S&P 500 lost half of its value.

Market conditions presently match those that have repeatedly preceded either market crashes or extended losses approaching 50% or more. Such losses have not always occurred immediately, but they have typically been significant enough to wipe out years of prior market gains. Aside from the 2000-2002 instance, they also have historically ended at valuations associated with prospective 10-year S&P 500 nominal total returns in excess of 10%. At present, reliable valuation measures are associated with estimated total returns for the S&P 500 of just 2.0% annually over the coming decade. On the basis of historically reliable measures, the S&P 500 would have to move slightly below the 1000 level to raise its prospective returns to a historically normal 10% annually. Given short-term interest rates near zero, economic disruptions would probably be required in order to produce that outcome over the completion of the current cycle, and we have no forecast or requirement for that to occur. Of course, there is no shortage of historically unreliable measures available to offer assurance that equity valuations are just fine.

Regardless of whether the market’s losses in this cycle turn out to be closer to 32% (which is the average run-of-the-mill bear market loss) or greater than 50% (which would be required to take historically reliable valuation measures to historical norms, though most bear markets have continued to undervalued levels), it’s going to be difficult to avoid steep losses without a plan of action. In our view, that action should be rather immediate even if the market’s losses are not. However uncomfortable it might be in the shorter-term, the historical evidence suggests that once overvalued, overbought, overbullish conditions become as extreme as they are today, it’s advisable to panic before everyone else does.

Meanwhile, our own approach remains to accept market risk in proportion to the return/risk profile we estimate based on observable conditions at each point in time. That has kept us out for quite a while, because history does not teach us to speculate until market conditions become as extreme as they are at present. It only teaches that steep losses typically follow once they do.

We are emphatic about two points here:

1. The extreme conditions that we observe today do not necessarily resolve into near-term predictions about market direction. Historically, the most severe overvalued, overbought, overbullish syndromes do not precisely overlap market peaks, and occasionally precede them by months or quarters before they are resolved by steep losses. The eventuality of steep losses is predictable, but the timing is not. Speaking very generally, similar extremes in history followed 5-year diagonal advances and were followed by 2-year collapses. Still, aside from the view that conditions are already extreme and monetary policy is an unreliable and receding support, yield-seeking speculation has played an enormous psychological role in the recent half-cycle, and marking turning points has not been our strong suit;
   
   
2. Our own challenging experience since 2009 is not an adequate reason to ignore the objective historical evidence here. Our experience in recent years is not the reflection of a static investment method. It began with my insistence, at the height of our success in 2009, on ensuring that our methods were robust to Depression-era outcomes. While I saw that as a fiduciary responsibility, the decision immediately resulted in missed gains early in this half-cycle. And while the ensemble methods that we introduced in 2010 performed better in complete historical cycles than any approach we’ve tested, repeated bouts of quantitative easing then required us to reintroduce certain bubble-tolerant features of our pre-2009 methods as an overlay (mostly relating to what we called "trend uniformity" during the late-1990's bubble). The combined result was an unexpectedly difficult and awkward transition from our pre-2009 methods to our present methods. Ironically, both methods of classifying market return/risk conditions capably navigate market cycles across a century of history (though our present methods handle Depression-era data better), including the current cycle, had either method been in practice without that transition (See Setting the Record Straight).

We remain fully confident in the ability of our investment discipline to navigate the completion of the present market cycle and those that follow. My apologies to regular readers for repeating our discussion of our stress-testing narrative since 2009 – but the incorrect belief that our experience in the recent half-cycle traces to our strategy itself and not that stress-testing transition continues to be the source of endless second-guessing, not to mention well-meaning suggestions that we’ve already addressed in recent years to the greatest extent that the historical evidence supports.

Ongoing research is a central component of our discipline. Where we can identify considerations, supported by historical evidence, that would improve our investment discipline in a way that can be validated across prior market cycles, we eagerly incorporate that new knowledge into our approach. But where we are asked to suspend our respect for the lessons of history, and to embrace speculation on the basis of popular theories that lack support in a century of evidence, we have to refuse. That refusal undoubtedly comes with a price, sometimes to our returns, and often to our popularity. Sometimes our respect for history will harm us instead of helping us, as has been true – at least to date – of my decision to stress-test against Depression-era data. Regardless, we continue to pursue a historically-informed approach in the expectation – vindicated again and again through time – that the benefits of discipline are ultimately greater, and the costs ultimately smaller than the alternative of believing “this time is different.”

With regard to the market outlook, our present views are not built on the forecast that stocks must decline immediately, or that we won’t go through some additional discomfort if the market pushes to a higher peak. Still, a century of history strongly warns that whatever transitory gains the market achieves from present levels will be wiped out in spades, with little opportunity (particularly given thin trading volume) for more than small set of investors to actually retain those gains over the completion of this cycle.

A reminder: The first sell-off in the typical bear market averages 10-12%. By that point, investors often feel that stocks have declined too far to sell, and are heartened by the partial recovery that typically follows. The same sequence generally repeats many times over, with one or two much deeper free-falls along the way. It may be useful to walk through the full course of past market cycles to get a sense of how they are completed. As Mark Twain wrote, “History does not repeat itself, but it does rhyme.”

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.

Fund Notes

The Hussman Funds continue to hedge against equity market risk at present. That will change. The strongest market return/risk profiles we estimate are associated with a significant retreat in valuations coupled with early improvement in our measures of market internals. Valuations do not have to retreat to historical norms, and certainly not to undervalued levels, to encourage a constructive stance in that event. Still, it is speculation – not investment – to accept market risk at a point where historically reliable measures of valuation are double their historical norms, following a diagonal 5-year advance that has now produced among the most extreme levels of bullish sentiment in history.

I remain convinced that opportunities for strong and durable investment gains will emerge over the course of the coming market cycle, and that historically-informed investors should be willing – and can afford – to miss whatever further speculative gains emerge prior to the downward completion of the present cycle. It’s not unusual for a run-of-the-mill bear market to wipe out years of prior market gains. The 2000-2002 and 2007-2009 declines wiped out the entire total return of the S&P 500, in excess of Treasury bills, back to May 1996 and June 1995, respectively. As I’ve detailed in prior comments, present overvalued, overbought, overbullish conditions fall into a small subset of historical instances that include in 2007, 2000, 1987, 1972 and 1929.

Our discipline is to align our investment stance with the market return/risk profile that we estimate at each point in time. The size of our response to expected return/risk is determined by our tolerance for risk over the complete market cycle. It’s also best to understand that we place little weight on whether our own gains and losses occur at the same time that passive investors are gaining or losing.

On the subject of risk tolerance, recall that a typical, run-of-the-mill cyclical bear in the stock market comprises a loss of about 32% (though the most recent bear markets have been far worse). It’s not impossible, but none of the Hussman Funds has experienced a loss of that extent. Remember also how compounding works. A 32% loss turns a 100% gain into a 36% gain. The 55% market loss in 2007-2009 was equivalent to an initial 25% loss, followed immediately by an additional loss of 40% from there. At market peaks, investors easily forget the extent to which bull market gains are erased over the completion of the typical cycle.

A few notes on hedging may also be useful. When our market return/risk estimates are severely negative, the Strategic Growth Fund “staggers” the strike prices of its index option hedges (raising the strike prices of our long index put options higher than the strike price of the short call side). While we expect to benefit from such positions on average over the course of the market cycle, they can result in additional decay of put option value when hostile conditions are accompanied by yet further market gains.

We’ve done a great deal to restrict the frequency of staggered-strike positions without giving up the significant benefit that we estimate from their use in historical tests across a century of market cycles. The ensemble methods that resulted from our 2009-2010 stress-testing significantly outperformed our pre-2009 methods in historical data, but repeated bouts of Fed-induced yield-seeking eventually led us to reintroduce certain “bubble-tolerant” features of those pre-2009 methods as an overlay (see the 2012 Annual Report for a discussion). The overlay incorporated into our current methods is not so tolerant that it prevents us from holding a staggered-strike hedge here, but it would reduce the frequency of staggered strike positions to less than 20% of the period since 2009, which is much less frequent than without the overlay. More than half of the instances that remain are in the months since mid-2013, and nearly all have been since early-2012.

In market cycles across history, market extremes with a return/risk profile negative enough to encourage a staggered-strike position occur in only about 5% of the data. A fully-hedged stance is associated with about 31% of historical conditions, with a partially hedged stance about 12% of the time, and a leveraged position (unhedged, but with a few percent of assets in index call options) about 52% of the time. There’s no assurance that future market cycles will conform to these averages, but I strongly expect the profile of the Fund’s investment stance to be more constructive and even aggressive over the course of future market cycles than our stress-testing “miss” in the half-cycle since the 2009 low might suggest. The Strategic Growth Fund’s favorable experience in the 2000-2007 market cycle (measuring from market peak to market peak) is a useful example of varying our investment stance - even moderately - in response to prevailing conditions. In the absence of stress-testing issues, and despite valuations in 2003 that were still far above historical norms, we were able to remove the majority of our hedges in early 2003. Not surprisingly, that constructive shift was encouraged by a retreat in market valuations coupled with an early improvement in our measures of market internals.

Quite often, and by construction, strategies that align investment exposure with the market’s risk/return profile do not track market movements over portions of the market cycle, and may even move somewhat opposite to the market (which is often quite welcome, but other times not). Over the course of a full cycle, this can have a useful diversification benefit as part of a portfolio, but it promises frustration for those who have a strong desire to track market movements over shorter portions of the cycle. Our investment discipline is not suitable for those investors.

My impression is that as in 2000 and 2007, alternative investment strategies that are imperfectly correlated with the broad market may be useful to investors over the next few years, whereas a shift to greater market sensitivity may be useful after a significant retreat in valuations is coupled with an improvement in market internals. Having addressed the stress-testing challenges of the half-cycle since 2009, and with the confidence that we are well-prepared to respond to shifting market conditions over the completion of the present cycle and in future ones, nearly all of my investments are in the Hussman Funds, with Strategic Growth Fund my largest holding among them. Such an allocation is not suitable for those that do not share a full-cycle investment horizon (in particular, known expenses that will occur in a small number of years should generally be funded with fairly riskless and short-duration investments), or who desire to closely track major market indices (which generally favors passive buy-and-hold strategies).

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The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

Prospectuses for the Hussman Strategic Growth Fund, the Hussman Strategic Total Return Fund, the Hussman Strategic International Fund, and the Hussman Strategic Dividend Value Fund, as well as Fund reports and other information, are available by clicking "The Funds" menu button from any page of this website.

Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).