Left field slugger

As Guambat has often noted, he sees himself as a bit of a left field hitter: he sees an opportunity coming but swings too soon to get a good piece of it.

But whereas Guambat is such a poor left field hitter that he tends to foul out past the extreme left field foul line, some left field hitters manage to keep the ball on the in bounds side of the foul line, and hit it into the far left field stands for a home run.

One such slugger is John Hussman, of whom Guambat has on occasion admiringly spoken and cited.

The thing about Hussman is that he has, for the last several years to a decade, been extremely wary of the market conditions, as a quick review of the citations just mentioned reveal. So cautious has he been that many consider him to be leading bear voice, if not a perma-bear.

Guambat just considers him to be a left field slugger because, though he did miss the last and biggest spikes of the recent bull run because he hit to the left field ahead of the ball and arguably "got out" (well, got conservative in his holdings, anyway) too soon, he did also miss the crash that has caught so many bulls by the balls.

So now he's stepping up to the plate with a big bat and this time looking to hit a bull ball to left field. He's been "averaging in" to this idea for a little while, as you can see from his excellent weekly commentaries here.

The evolution of his thinking had taken shape by the time on October 20th when he wrote:

The best way to begin this comment is to reiterate that U.S. stocks are now undervalued. I realize how unusual that might sound, given my persistent assertions during the past decade that stocks were strenuously overvalued (with a brief exception in 2003). Still, it is important to understand that a price decline of over 40% (and even more in some indices) completely changes the game.

In 2000, we could confidently assert that stocks would most probably deliver negative total returns over the following 10-year period. Today, we can comfortably expect 8-10% total returns even without assuming any material increase in price-to-normalized-earnings multiples. Given a modest expansion in multiples, a passive investment in the S&P 500 can be expected to achieve total returns well in excess of 10% annually.

None of this is an argument that the market has necessarily registered either a near-term or a final bear market low.

He was warming to the idea in his November 10 report:

I continue to view stocks as somewhat undervalued, in that long-term investors can expect the S&P 500 to deliver total returns in the area of 10% annually over the coming decade. This is the largest expected return premium, relative to long-term Treasury yields, since the early 1980's.

These changes have significantly improved my views about market valuations and long-term return prospects, but I want to discourage any impression that stocks have “hit bottom” or that a new “bull market” is at hand. That sort of thinking isn't really helpful to investors, who should always be grounded in observable evidence (rather than trying to infer things like bottoms and turning points, which can only be identified in hindsight). Frankly, the idea of identifying those things in real time is wishful thinking. Investors should not rule out a continued bear market, or deeper lows, perhaps early next year (depending on the evolution of the economic evidence). Still, even in the context of a continued bear market, we may well observe a huge 25-35% trading range as evidence develops, pushing and pulling on the perceptions and expectations of investors. Better to be comfortable with uncertainty and thoughtfully adapt to observable evidence as it develops, rather than planting a flag in the ground and being trampled from both sides.

And his latest November 17th report puts his thinking in an historical context:

One of the fallacies about the recent financial turbulence is that the markets are in “uncharted territory” and that there are no historical precedents for the volatility, panic, or economic uncertainty that we've observed. To make statements like this is to admit that one has not examined historical evidence prior to the 1990's. The fact is that we've observed similar panics throughout market history. This decline has been deeper and more rapid than most, but that is largely a reflection of the rich valuation and overbought condition that characterized the market in 2007.

Sure, if U.S. unemployment is headed to 25%, as it did in the Great Depression, then stock prices might fall in half even from here, as they did by 1932. But this is important – even if stock prices were to fall further, it would not be because of earnings losses that would permanently impair the fundamental value of U.S. companies. Rather, if further losses emerge, it will be because of increases in risk premiums that will be associated with extremely high subsequent returns. Indeed, even though unemployment shot to 25% in 1932, the S&P 500 more than doubled in the year following the 1932 Depression low, and tripled off of that low within less than three years.

The handful of historical instances when stocks fell to 7 times prior record earnings were also points that were accompanied by 15-25% unemployment, 12% yields on commercial paper (as at the 1974 lows), or 15% Treasury yields (as at the 1982 lows). Similar data is unlikely in this instance

Meanwhile, it is notable that data that measure investor panic, such as risk-premiums and intra-day market volatility, already match historical extremes (1932, 1974, 1982, and 2002) – points where stock prices were not far from their lows even though negative economic news persisted for a longer period.

That's not to say that I believe stocks have “hit their lows.” We always have to allow for the market to move significantly and unexpectedly, and there is plausible downside risk from here. Our activity as investors is not to try to identify tops and bottoms – it is to constantly align our exposure to risk in proportion to the return that we can expect from that risk, given prevailing evidence.

Investors can get a good understanding of market history by examining a great deal of data, or by living through a lot of market cycles and learning something along the way. Only investors who have done neither believe that current conditions are “uncharted territory.” Veterans like Warren Buffett and Jeremy Grantham have a good handle on both historical data, and on the concept that stocks are a claim to a very long-term stream of future cash flows. They recognize that even wiping out a year or two of earnings does no major damage to the intrinsic value of companies with good balance sheets and strong competitive positions. Most importantly, these guys never changed their standards of value even when other investors were bubbling and gurgling about a new era of productivity where knowledge-based companies would make the business cycle obsolete, and where profit margins would never mean-revert. They knew to ignore the reckless optimism then, because they understood that stocks were claims on a very long-term stream of cash flows. They know to ignore the paralyzing fear now, because they still understand that stocks are a claim on a very long-term stream of cash flows. Stocks are not a claim on next quarter's or next year's earnings – they are a claim on an indefinite stream of future cash flows.

No thoughtful investor “calls a bottom” in the markets. Stocks are undervalued here, but they could decline further. Current market conditions are extremely compressed, to the extent that the market could soar by 30% even in the context of an ongoing bear market.

It is a typical market dynamic to have massive rallies toward prior levels of support, even within ongoing market declines. Once valuations are favorable, that tendency is even stronger, even in a weakening economy. Only the final panic decline of a bear market offers investors virtually no chance to get out on rebounds, but it is precisely that final decline that is recovered almost immediately in the subsequent bull market.

It's possible we've already seen the final panic of the current “bear market,” though we certainly wouldn't remove our hedges on that expectation. Given the slim prospects for an economic recovery in the near future, my impression is that regardless of what happens over the very near term, we'll observe an additional spate of weakness (possibly from higher levels) early next year as investors give up their remaining patience and decide –as they often do near the end of a bear market – that there's no way that the market or economy can recover, and that there is no “catalyst” that is capable of driving stocks higher.

It is important to establish exposure slowly, but long-term investors who ignore attractive valuations are not investors at all.

As I repeatedly noted when valuations were rich, gains in an overvalued market are generally not retained over the full market cycle. Likewise, weakness in an undervalued market tends to be temporary and impermanent. This distinction is essential. The main damage that investors can do to their financial security at this point would come from selling into steep but impermanent declines. Even in ongoing bear markets, once valuations become favorable, declines through prior levels of support are typically followed by advances back to that support. Remember that if and when things look frightening.

It is also important for investors to separate near-term earnings risks from long-term valuations. Earnings are more volatile than stock prices, and year-over-year fluctuations in earnings are not correlated at all with year-over-year fluctuations in stock prices. It is only over the long-term, when we examine stock prices versus the smooth trend of normalized earnings across multiple business cycles, that earnings really matter.

As a side note, do your best to filter out comments like “investors are moving out of stocks and into …” or “investors are selling into this decline” or “investors are buying into this rally.” On balance, investors do not sell shares, and they don't buy shares. Every share purchased is a share sold. The only question is what price movement is required to prompt a buyer and a seller to trade with each other. No money will come off the sidelines into stocks. No money will come out of stocks and onto the sidelines. All such talk is non-equilibrium idiocy. Keep in mind that the “market” consists of different traders with a variety of time-horizons, risk-tolerances, and analytical methods (e.g. technical, report-driven, value-conscious). It is helpful to think in terms of which group of individuals is likely to do what, and when. It is equally important to know which group of investors you belong to. As the old saying goes, if you're at a poker table and you don't know who the patsy is, you're the patsy.

John Hussman is an investor and not a trader, so, to some extent, reading his weekly reports is a bit like watching paint dry. But you are well advised to check in on his market commentary from time to time just for the education if not for the rush of animal spirits.