The message from John Hussman in his latest weekly market commentary, basically boils down to: investors can be dumb and ignorant of valuations, and unfortunately that requires us to just follow what they do, rather than attempt to use reason in order to figure out stock prices.
The whole thing is worth reading, but here’s the nut:
The S&P 500 is still below where it was a decade ago, and even with the benefit of its recent advance, has underperformed Treasury bills for nearly 13 years. The reason is that investors could not have cared less about valuations during the late-1990’s, and failed to recognise that they were still inappropriately rich between 2004-2007 (as they are again today). Speculators can get all kinds of enticing advances going over the short-term, but over time (complete market cycles and longer), regardless of whether one looks at post-war data or pre-war data, valuations determine the long-term returns that investors achieve in stocks.
As we move through the coming months, resolving the “two data sets” issue will help us to determine which set of historical precedents is relevant. If the current economic environment produces fresh credit strains similar to previous periods of credit difficulty in the U.S., Japan and elsewhere, valuations and margin of safety will remain the most important consideration in determining investment positions. If the economic situation reveals itself to be more like typical post-war cycles, valuations will still be an important consideration, but we’ll be better able to assume that speculation (provided sufficient evidence from market internals) will be reliable even in the absence of clear fundamental support from valuations.
I certainly don’t expect that the mortgage securities in bank portfolios and at agencies such as Fannie Mae and Freddie Mac will ultimately be made whole by cash flows paid by homeowners. But we can’t fully reject the possibility that the Fed and Treasury have kicked the can down the road far enough, and that the FASB has obscured disclosure sufficiently, that we’ll just gradually make mortgage securities whole over a period of years through bloated fiscal deficits and quiet bailout of these lenders. If we get through the next several months without a material shift in credit conditions, we’ll gradually revise our assumptions to reflect a “typical” post-war economic environment and set our investment exposures consistent with that. This doesn’t mean ignoring valuation, but it does mean being more responsive to speculative pressures and strategies that have been effective in post-war data.
And then a little bit of market philosphy:
Over the past decade, it has been an uncomfortable lesson to accept that investors can be relied on to behave in ways that are ultimately unsustainable and destructive to their wealth, as long as market internals are temporarily supportive. It’s one thing to say, “From every historical precedent, we know that this is going to end badly, and investors will lose a great deal of their wealth, but for now, they are speculating anyway.” It’s another thing to add, “and since they are, we are actually going to rely on investors to continue behaving dangerously, and join them.” Even though we’ve substantially outperformed the S&P 500 with smaller periodic losses over complete market cycles, there is no denying that periodicaly riding the coattails of speculators, so to speak, would have made our margin of outperformance even greater.
It’s unlikely, given the seriousness I place in being a fiduciary to shareholders (in some cases to their life savings), that I’ll ever completely submit to the idea of relying on the speculative impulses of investors, but I do recognise that we can probably accept a greater level of speculative risk going forward than we were willing to adopt coming off of a valuation bubble and a credit crisis with a latent second-leg still looming. I expect that clarity about the underlying economic conditions here will be helpful in striking that balance.
And then finally, a dig at CNBC for creating this mess, whereby investors are dumb and unable to correctly read the economic signals:
I’ve thought about this a great deal, and I suspect that just as the experience of patients is determined by the quality of information they get from their doctors, the behaviour of investors is likely to be only as sound as the quality of the discourse and advice they receive from investment professionals. In reflecting on why the past 15 years have been so riddled by irresponsible speculation, it is impossible to ignore the rise over that same period of widely-viewed financial programming that is equally riddled with cartoonish content that encourages short-term thinking and speculation (buy-buy-buy! sell-sell-sell! boo-yah!). When we observe a clear change in the quality of analysis on the financial news, and the departure of its more speculative elements, I suspect we’ll also see greater emphasis on fundamentals and better allocation of capital, while speculation will be less effective in the face of overvaluation.
During the late-1990’s bubble, it struck me that the discourse on CNBC was remarkably similar to the sort of discourse that I had read from news archives preceding the 1929 crash. As I wrote at the time, what was surprising was the extent to which investment professionals, who ought to have known better, were fully endorsing valuations that were clearly inconsistent (at the time, and certainly in hindsight) with prospective cash flows – even if one assumed that economic activity, earnings, and dividends would achieve and sustain the highest growth rates ever observed in history.