‘There is no perfect science to investing. For me, it’s part technical analysis, mathematics, appreciation of market history, common sense, experience, and intuition. Not all parts are equal, but collectively they help formulate an opinion on how best to achieve my personal objectives.’
The Gowdie Letter, 22 April 2016
Many years ago I recall hearing the then ASIC Chairman say, ‘Show me someone who hasn’t made a loss and I’ll show you someone who hasn’t invested.’
Our investment wins and losses are all part of the education process. In my opinion, your long term best interest is better served by losing a little early rather than winning a lot early.
Before committing me to institutional care for publicly airing that thought, please hear me out.
When money comes easily, people can be deluded into thinking they have the Midas touch, when the truth is it may have just been a case of ‘right time and right place’. Repeating that success — lightning striking twice — becomes harder.
The more a person believes they have the Midas touch — think Nathan Tinkler, Babcock & Brown, Alan Bond, Christopher Skase — the more likely they are to roll the dice with bigger bets. Success can breed arrogance, and arrogance is the kiss of death for an investor.
Losing a little early on teaches you to respect the markets. It makes you question your assumptions. You think about the motives and experience of those giving you advice. You consider the risks.
Those early — and hopefully not too serious — losses can be thought of as school fees. The price paid to learn valuable lessons.
Last Christmas we gave our daughters a gift of some money to invest…with strings attached. To release the funds, they had to present their investment case. Research, reasons why they felt the investment would succeed, risk assessment, and their exit strategy.
Part of me is hoping the investments (when made) do not succeed. They will learn far more from failure than any textbook or my ‘preachings’ could ever teach them. The psychological impact of a loss is said to be three times greater than that of a win. Losses hurt.
My past losses are the reason why I place so much emphasis on assessing the downside.
As I explained last week, my investment approach has been formulated from a combination of factors. History and maths play an important part in influencing my decisions.
However, I recognise that in the current environment there could be a problem with relying on history and maths. We have never witnessed such a coordinated effort by central banks to prop up economic activity and asset prices.
An extended period of zero and negative interest rates, creating trillions out of thin air, and Central Banks actively engaged (directly or indirectly) in the buying of government bonds and shares, are all without precedent.
The actions of central bankers have grossly distorted markets.
Even seriously smart and seasoned investors are scratching their heads and wondering how this intervention all ends without massive dislocation in markets and the economy. If they cannot figure it out, what hope do we mere investment mortals have?
No one knows, because no one has ever been here before. There are many questions I ask myself.
Are history and historic valuation models still relevant?
What weighting do we put on the future forecasts included in last week’s The Gowdie Letter — Jeremy Grantham’s seven year forecast and the Shiller PE 10 Implied future (eight year) return?
Or, are central banks arrogantly believing they’re more powerful than markets — a classic case of initial success breeding long term failure?
Common sense tells me a handful of academics cannot outsmart the market indefinitely. The system is far too complex to control, and the unintended consequences of their extraordinary endeavours to maintain business as usual are likely to be devastating.
The question for me is distilled down to this: In which do you have more faith, the central bankers or the markets?
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A 100% knockout record
By my count, the markets have a 100% knock out record. Never in the history of markets have they failed to correct the imbalances in the system. Albeit the timeframe for each correction can vary dramatically…it took over 70 years for communism to be officially declared a failure. (Though best not tell Kim Jong-un.)
Based on the premise that markets ultimately hold sway, this week I want to share a couple of charts from Hussman Funds with you. John Hussman (a former professor of economics and international finance at the University of Michigan) does an enormous amount of technical and historical research to determine how best to position his investment fund.
He is not always right in his assessment. While he called the GFC and profited handsomely from getting this right, he did not anticipate the Fed’s extraordinary response post-2009. The performance of his fund suffered from not being exposed to the rising US share market. A mistake he readily acknowledges.
In spite of that, I like his research. Short term underperformance does not concern me, if the rationale behind that result was sound. Personally, I’d rather have 100% of my capital earning 2% with minimal downside, than earning 7% with the potential for a 50+% fall.
The following graph from Hussman Funds — dating back 70 years — tracks the ratio between the value of businesses (market capitalisation) compared to the value of goods and services produced (Gross Value Added, ‘GVA’).
Source: Hussman Strategic Advisors
This is John Hussman’s assessment of the current reading:
Based on valuation measures having the strongest correlation with actual subsequent market returns across history, equity valuations have approached present levels in only a handful of instances: 1901 (followed by a -46% market retreat over the following 3-year period), 1906 (followed by a -45% retreat over the following year), 1929 (followed by a -89% collapse over the following 3 years), 1937 (followed by a -48% loss over the following year), 2000 (followed by a -49% market loss over the following 2 years), and 2007 (followed by a -57% market loss over the following 2 years). A few lesser extremes occurred in the 1960s and 1970s, followed by market losses in the -35% to -48% range.
Just to summarise, when readings have previously registered in the current range, it’s resulted in six major downturns. 1901, 1906, 1929, 1937, 2000 and 2007. The corrections have ranged in magnitude from minus 45% to minus 89%.
Dismiss history at your own peril
Do you dismiss this historic context, or do you factor it in to your risk versus reward calculation?
Personally, I factor it in.
The following chart inverts the readings from the above chart (blue line to the left hand scale).
The red line is the subsequent 12-year return based on the reading.
According to John Hussman (emphasis mine):
‘The chart below updates the ratio of nonfinancial market capitalization to corporate gross value added, which we find more tightly correlated with actual subsequent 10-12 year returns than any other measure we’ve tested across history (including price/forward earnings, the Fed model, CAPE, and numerous other metrics).
Source: Hussman Strategic Advisors
Since 1950 there’s been a very tight correlation between the blue ‘value’ line and the red ’12-year return’ line.
The current reading indicates the return from the US share market for the next 12 years (2015–2027), will be in the vicinity of 2% per annum.
This number fits in with the future returns predicted by Jeremy Grantham and Shiller PE 10.
Do we ignore this in the hope the central bankers have created a market that defies gravity indefinitely? Or do we heed the warning?
As stated previously, the market will not deliver a steady 2% per annum and be done with it.
No. The market will take you up hill and down dale to reach that return.
Look at the above chart from the predicted 12 year return from 2000 to 2012. The blue line indicated the return would be around minus 1% per annum. The actual result (red line) came in around 0% per annum.
Look at the following chart of the S&P 500 from 2000 to 2012. You can see how the market zigged and zagged its way to reach a result of 0% per annum.
Source: Yahoo Finance
One more example for you. Assume it’s 2000 and you decide to heed the message in Hussman’s valuation versus future return table and wait two to three years.
The predicted return from 2003 to 2015 was around 10% per annum. The red line confirms this is what happened — see the S&P graph for confirmation, with the S&P rising from 800 points to 2000 points over the period.
There’s every likelihood in the coming months or years that we’ll have a repeat of one of those six major downturns, ranging from minus 45% to minus 89%.
The actual timeframe is anyone’s guess. But the question you have to ask yourself is, do you want to chase the last bit on offer from this market hoping you are smart and quick enough to exit before the proverbial hits the fan?
Or do you want to wait on the sidelines (with varying degrees of frustration) for a lower risk higher reward opportunity to present itself?’
The lessons learned from my earlier mistakes have made me well aware of my limitations. I am neither smart nor quick enough to play the ‘squeeze the last drop’ game very well.
So I sit and wait.
Editor, The Gowdie Letter
Ed note: This article was originally published in The Gowdie Letter.