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“How Much Does the Market Have to Decline Before you Become Constructive?”

This is a question John Hussman received recently.  His answer:

“At present, a market decline of about 20% would raise our estimate of 10-year prospective returns to somewhere around 6.5% annually, which is still below-average but not intolerable. Even a smaller decline would still allow a constructive investment stance. In both cases, we would require our measures of market action to be positive: favorable trend-following measures and market internals, without hostile indicator syndromes. The problem with a shallow decline is that a constructive position would probably not be sustained for long because overbought conditions or other negative factors could emerge fairly quickly – which is what we’ve repeatedly observed since 2010.

Undoubtedly, the most favorable outcome would entail a market loss deeply in excess of 20% followed by an improvement in market internals – which is the typical way that a market cycle is completed. That would allow a good deal of latitude for the market to advance without shifting back to an overvalued, overbought, overbullish condition or some other hostile syndrome. We certainly don’t need stocks to become undervalued in order to establish a constructive position, nor do we require valuations to normalize in one fell swoop. A large improvement in valuations would be desirable, but a smaller improvement would be adequate provided that we can clear the abysmal set of conditions that we presently observe.”

I find this question interesting.  It’s one that permabears can never quite answer adequately (not that John Hussman is a permabear).  But it’s a question that has been plaguing investors for years now as they wait for that perfect 2008 moment all over again.  Many investors are convinced that if they just get one more crack at it they’ll get it right next time and buy at the lows and it will be smooth sailing. It’s a common bias that inflicts harm on many investors.  Thing is, the next time seems to perpetually evade them or when it comes, they freeze and don’t react as they wanted to.   This is one reason why I like to automate and diversify across different strategies.  This eliminates the need to ever ask yourself the above question.  After all, if you have to ask yourself the above question then you’re probably doing something wrong.

Here’s how I think of it.  The reality about investing capital is that it is a residual of what your primary production is.  If you’re productive and believe that the society you reside in will remain productive then we should expect future output and profits to increase in the future.  That should be bullish for most traditional asset classes like bonds and equities.  Human beings have an uncanny knack for making progress. In fact, I’ve argued it’s an inherent trait that differentiates us from many other animals.  Betting against this is like betting against you waking up in the morning.  It’s almost always a bad bet.  So being bearish in the very long-run is never very wise.

So, if you’re optimistic about your ability to produce and the ability of the society around you to produce then you need to design your investment portfolio around the idea that the best investment you’ll ever make is in yourself.  Any leftover is residual that should go into an automated investment portfolio of some sort (whether it be actively managed or passive) that has a long-term bullish view, but is managed in a prudent manner that aligns your overall needs with realistic targets for your monetary needs.  The vast majority of people don’t need 20% annualized returns in an investment portfolio and in fact shouldn’t be taking the risk required to achieve that.  Most investors need to maximize personal output and hedge any residual investment portfolio in a manner that protects from losing purchasing power and manages the risks in a manner that protects from the potential of permanent loss.

The bottom line is: if you spend your time worrying about catching the next falling knife to save your portfolio then you’re probably doing something wrong to begin with.

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