A deeply important subject that hasn't really mattered much over the last decade, or as Mr. Hussman phrases it:
From Hussman Funds, January 14:
Return-Free Risk
The main adaptation that deranged Federal Reserve policy required of our own discipline in this cycle was to abandon our pre-emptive bearish response to historically-reliable ‘limits’ to speculation, and to instead prioritize the condition of market internals (which have been part of our discipline since 1988). Essentially, we became content to gauge the presence or absence of speculation or risk-aversion, without assuming that there remains any well-defined limit to either. A more recent – though minor – adaptation has been to adopt a slightly more ‘permissive’ threshold in our gauge of market internals when interest rates are near zero and certain measures of risk-aversion are well-behaved. The main effect is to promote a more constructive shift following material market losses.
The question isn’t whether one should adapt to unprecedented Fed policies, but instead, the form those adaptations should take. We are fully convinced that these historic valuation extremes have removed decades of investment returns from the future, and strongly suspect that the Fed has amplified future downside risk as well. I believe investors have placed themselves in a position that is likely to be rewarded by a very long, interesting trip to nowhere over the coming 10-20 years. At worst, they may discover the hard way that a retreat merely to historically run-of-the-mill valuations really does imply a two-thirds loss in the S&P 500. Still, our research efforts in recent years have focused on adaptations that can allow us to better tolerate and even thrive in a world where valuations might never again retreat to their historical norms. We don’t actually expect that sort of world, but have allowed for it.
– John P. Hussman, Ph.D., Maladaptive Beliefs, September 2021
In an economy where the Fed has lost every systematic tether to common sense, empirical evidence, and concern for financial stability, it’s worth beginning this first market comment of 2022 by recalling the ways we’ve adapted in order to navigate that environment. In a world where securities are regularly described on CNBC as “plays,” it’s clear is that the financial markets presently have little to do with “investment” – at least not by Benjamin Graham’s definition as “an operation that, upon thorough analysis, promises safety of principal and an adequate return.”
It may be true that zero interest rates provide investors “no alternative” but to speculate. But as Graham emphasized, there are many ways in which speculation can be unintelligent. The first of these is speculating when you think you are investing.
I cringe when I hear analysts talking as if any dividend yield above zero is “better” than zero interest rates. That argument relies entirely on ruling out even the smallest decline in price, and the smallest retreat from current valuation extremes. The dividend yield of the S&P 500 is just 1.3% here. It was lower only in the quarters surrounding the 2000 bubble peak. The run-of-the-mill historical norm is about 3.7%.
Those of you who are familiar with finance can prove to yourself that the effective “duration” of stocks (the weighted-average number of years needed for present value to be repaid by cash flows, and the sensitivity of the market price to changes in the discount rate) works out mathematically to be approximately the price/dividend multiple. From that perspective, one can think of the S&P 500 as being a 77-year duration investment here, compared with a historical norm closer to 27 years.
Depending on market conditions, stocks can have “investment merit,” “speculative merit,” both, or neither. In our own discipline, we gauge “investment merit” by valuation – the relationship between the price of a security and the long-term stream of expected cash flows that we expect that security to deliver over time. We gauge “speculative merit” based on the uniformity or divergence of market internals. When investors are inclined to speculate, they tend to be indiscriminate about it. Since 1998, our most reliable gauge of speculation versus risk-aversion has been based on the signal we extract from the market action of thousands of individual securities, industries, sectors, and security-types, including debt securities of varying creditworthiness.
The single difference between the most recent market cycle and other cycles across history is that in every other cycle, speculation always had a well-defined limit. We gauged those extremes based on what I describe as “overvalued, overbought, overbullish” syndromes. Unfortunately, zero interest rates have proved to be a kind of acid that burns through every shred of intellect, driving investors to imagine that any asset that varies in price – regardless of how extreme its valuation or how uncertain its underlying cash flows – is better than zero-interest cash. My error in this cycle was to believe that speculation still had well-defined limits. In late-2017, I abandoned that view, and became content to gauge speculation versus risk-aversion based on the condition of market internals. Since then, we’ve refrained from adopting or amplifying a bearish outlook when our measures of internals are constructive, regardless of how extreme valuations might be....
....MUCH MORE
Put another way:
"I have two problems but only one tool."
-Ben Bernanke
Testimony to the House Budget Committee
Jan. 16, 2008
