June 6, 2016

Over-Adaptation and Market Drawdowns

John P. Hussman, Ph.D.

The speculative premise here, as well as I can discern, seems to be that low short-term interest rates are “good” for the financial markets, and that in the absence of a material increase in interest rates by the Federal Reserve, speculative assets such as stocks, corporate credit, and even junk debt will be naturally driven higher, because they represent a desirable alternative to low-yielding, default-free liquidity. According to this premise, the fact, alone, that the S&P 500 dividend yield of 2.17% is higher than the 10-year Treasury yield of 1.71% should make it clear to anyone that stocks are still a competitive investment. The expectation of future dividend growth, then, only makes a compelling case more so. 

I think that’s the logic. 

The one little problem is that it wholly ignores precisely the thing that makes all of those speculative assets different from low-yielding, default-free liquidity: 

Risk. 

The argument follows only to the extent than one can rule out capital losses. See, the speculative premise outlined above comes with some verifiable implications. For example, we should expect that periods of low interest rates should be associated, generally, with shallower overall market losses across history. Unfortunately, just the reverse is true. The chart below shows data from 1926 to the present, plotting the loss in the Dow Jones Industrial average from its highest level of the preceding 2-year period, against the average Treasury bill yield over that period. Notably, the deepest market losses (those that followed the 1929, 1937, 2000, and 2007 market peaks) were actually associated with relatively low short-term yields.

Finally, for passive buy-and-hold investors, I don’t advocate any deviation from your discipline, but it’s important to align your portfolio both with your tolerance for loss, and with your investment horizon. 

At current valuations, the S&P 500 is effectively an asset with a nearly 50-year duration. At historically normal valuations the effective duration would be closer to 25 years. Simply from the standpoint of aligning the duration of one’s assets with the duration of one’s spending plans, a passive investor should hold a smaller position in equities, as a fraction of their total assets, than they would if valuations were in a lower range. That’s not market timing; it’s straightforward financial planning. 

You don’t need to act on our expectation of a 40-55% market loss over the completion of this cycle, but do consider your ability to maintain your discipline, and be sure now that you could tolerate that outcome. Central bankers encouraged speculation in the recent half-cycle well after extreme and historically reliable warning signs emerged, and we had to adapt accordingly, but our concerns have repeatedly been correct over the completion of prior market cycles, and to the correct magnitude.

DYI