Excerpted from John Hussman's Weekly Market Comment [6],
The uncorrected half-cycle advance since 2009 has been accompanied by a resurgence of proponents advocating that stocks should simply be bought and held indefinitely, regardless of price. Some of these proponents have also used this mid-cycle victory-at-halftime as an opportunity to be rather impolite about it. On this subject, Graham and Dodd offer a useful warning in their 80-year old masterpiece, Security Analysis, speaking about the advance to the 1929 peak (whose valuations the present speculative episode has already matched or surpassed):
“Irrationality could not go further; yet it is important to note that mass speculation can flourish only in such an atmosphere of illogic and unreality. The self-deception of the mass speculator must, however, have its element of justification. This is usually some generalized statement, sound enough within its proper field, but twisted to fit the speculative mania… In the new-era bull market, the ‘rational’ basis was the record of long-term improvement shown by diversified stock holdings. There was, however, a radical fallacy involved in the new-era application of this historical fact. This should be apparent from even a superficial examination of the data contained in the small and rather sketchy volume from which the new-era theory may be said to have sprung. The book is entitled Common Stocks as Long Term Investments, by Edgar Lawrence Smith, published in 1924.
“In fact their rush to take advantage of the inherent attractiveness of common stocks itself produced conditions entirely different from those which had given rise to this attractiveness and upon which it basically depended [viz. much lower starting valuations in previous years]… But as soon as the price was advanced to a much higher price in relation to earnings, this advantage disappeared, and with it disappeared the entire theoretical basis for investment purchases of common stocks.”
I have no inclination to throw stones at buy-and-hold advocates. We’ve certainly had our own stumbles in the half-cycle since the 2009 low, partly because of my 2009-2010 insistence on stress-testing our approach against Depression-era outcomes, and partly because overvalued, overbullish, overbought syndromes that have been a crucial warning in prior market cycles have persisted much longer without consequence in this cycle, as a result of Fed-induced yield-seeking speculation.
Still, we do encourage buy-and-hold investors to understand and mentally prepare for the potential depth of interim losses inherent in that strategy (we would presently allow 40-55%). We also urge investors to align the proportion of assets in equities with the date that they’ll actually need the money. For funds that will be spent an average of 15 years into the future, with no new investment contributions, we believe that equity holdings should be limited to about 30% of assets strictly on the basis of duration (the S&P 500 presently has an estimated duration of about 50 years). This doesn’t even consider the fact that we expect only very low single-digit total returns for the S&P 500 over that horizon.
Following Graham, we go back to the importance of arithemetic in understanding why buy-and-hold strategies regularly reach their height of popularity at moments like the present. The returns that major stock market indices achieve over time can be reliably understood from the standpoint of where valuations stand at the start of a given window, and where they are at the end. At extremely elevated valuations, as we presently observe (on measures that are actually historically reliable), the past total returns of a buy-and-hold approach will always look quite favorable, because the backward-looking performance window ends at a quite favorable point. But this also generally means that the forward-looking performance window starts at the worst possible point, and unless valuations also happen to be elevated at the end of that window, future total returns are likely to be quite disappointing.
From this perspective, it is only because present valuations are so extreme that the total returns of the S&P 500 since the similarly extreme 2000 peak have worked out to be even modestly positive, at about 3.9% annually. We would suggest that this is a temporary artifact of severely elevated valuations at both the start and end of the 2000-2014 window. Whatever benefits investors perceive from the extreme elevation of mid-cycle valuations today are likely to be transitory. Following a largely uncorrected multi-year diagonal advance, it's exactly the illusion that risk is riskless and elevated valuations have reached a "permanently high plateau" that does so much violence to investors over the completion of the market cycle. It's a regularity that prompted me to quote from the Wallace Stevens poem Sunday Morning as the market approached the 2007 peak:
Does ripe fruit never fall? Or do the boughs hang always heavy in that perfect sky?
As in every cycle, we expect there will be very good opportunities to establish constructive or even aggressive exposure to market fluctuations, typically at the point that a material retreat in valuations is coupled with an early improvement in market internals. In the half-cycle since 2009, we admittedly missed those opportunities in the interim of our stress-testing response to the financial crisis. The absence of any material consequence of increasingly extreme overvalued, overbought, overbullish conditions – largely driven by speculative yield-seeking in response to quantitative easing – has been equally humbling. Those stress-testing considerations are behind us, and we’ve adapted to the potential for recurrent Fed-induced speculation in ways that we certainly expect to be evident as the present cycle is completed and future ones unfold. But what can actually be expected to be a predominantly bullish bias to our investment discipline is simply not going to be evident at an overvalued, overbought, overbullish extreme like we observe at present. I can only say that investors who view me as a permabear understand nothing about our discipline if they fail to understand the context behind our experience in the half-cycle since 2009.
Now, if one wishes to cite our experience during the half-cycle since 2009 as a justification to ignore overvalued, overbought, overbullish extremes indefinitely, that’s actually both welcome and useful, as someone will have to hold stocks through the completion of the present cycle. It’s best for those bag-holders to be people who have at least evaluated and voluntarily dismissed our concerns. Persistent and unconditional bullishness allows other investors – particularly those with short investment horizons – some window of opportunity to defend capital and reduce their portfolio risk to appropriate levels. Frankly, we’re not looking for investors to agree with us, or even to convert to our investment discipline. Our approach has always been to speak our truth plainly, and to do our utmost to maintain and encourage discipline for those who trust our efforts. Despite fiduciary stress-testing inclinations that, in hindsight, were not helpful during this half-cycle, we’ll let time sort out the misperceptions that investors have adopted in recent years about valuations, speculation without consequence, and even the inherent bullishness or bearishness of our own approach.
Meanwhile, we don't require an epic market loss in order to justify a shift to greater market exposure, and we expect that a significant portion of future opportunities will be on the constructive side (particularly once a material retreat in valuations is coupled with an early improvement in market internals). Here and now, however, we do remain concerned that there is a cliff at the edge of what appears to be a permanently high plateau.
