July 11, 2016
John P. Hussman, Ph.D.
Meanwhile, in the face all this yield-seeking speculation, investors seem to have forgotten how securities actually work. Understand that by purchasing securities at extreme valuations, you are necessarily playing a “greater fool” game that relies on a) successfully exiting at some point and; b) exiting at higher valuations and even lower long-term expected returns than those that are baked into the cake already. Not content with the current obscene overvaluation of the financial markets, central banks have tried to extend this game by driving bond yields negative. But those who buy a negative yielding asset, by definition, are locking in a loss if they hold to maturity, so in order to attain even a zero return, those investors have to rely on a greater fool to buy the bonds at yet deeper negative interest rates before they mature.
In that environment, it’s certainly possible that the current 1.36% yield on 10-year Treasury bonds will be driven even lower, and that equity valuations that are already more than double their historical norms will be driven even higher. We’d give greater odds to Treasury bonds, largely because U.S. economic weakness could create a flight to safety in Treasuries (while stocks and credit-sensitive debt would be vulnerable). But then what?
In market cycles across history, the best opportunity to increase market exposure, at a dramatically higher expected return/risk profiles, has been after a material retreat in valuations is joined by an early improvement in market action. These opportunities have emerged during the completion of every cycle, and I remain convinced that this one will be no different. In the meantime, realize that low-yielding cash has now become quite competitive with the prospective return/risk profiles of far riskier assets. We strongly encourage investors to continue to save in a disciplined way, but to lean strongly toward conservative assets including cash (yes, cash), hedged-equity, modest exposure to precious metals, and substantially reduced exposure to unhedged conventional assets such as stocks and bonds.
I have little doubt that future generations will look at the reckless arrogance of today’s central bankers no differently than we view speculators in the South Sea Bubble and the Dutch Tulip-mania. Unfortunately, there is no mechanism by which historically-informed pleas of “no, stop, don’t!” will penetrate their dogmatic conceit. Nor can we change the psychology of investors. The best we can do is to monitor the best measures we can identify of risk-seeking or risk-aversion.DYI: Valuations are at obscene levels so much so DYI's weighted averaging formula has "kick us out" of stocks and long term bonds and rightfully so! It is weighted when valuations cross the average to the upside the allocation decreases your position proportionally greater and as you suspect, as valuations crosses the average to the downside allocation is increased proportionally greater. You are doing exactly as you should buying increasingly more as valuations become cheaper and cheaper and decreasing more and more as valuations become more and more expensive.
Sounds great. So what's the catch? This goes exactly against the grain of human nature! Using stocks as an example when stocks drop increasing their valuation you will begin with small percentage increases. As valuations improve further you increase even more. Of course the bulk of improvement in valuations are due to stocks dropping. So....The greater the drop in prices valuations improve along with increased future returns. This could very easily go on for years before stocks bottom out. Greater the pain to the downside the more you increase your percentage allocation.
On an emotional basis a person may feel they are throwing good money after bad. Those who understand simple math is it better to compound money at 2% or 6%? This is not a trick question. 6% is better than 2%. The S&P 500 today its dividend yield as of 7-8-16 is 2.06% the average yield since 1871 is "drum roll please" 4.39%. The compounding difference is staggering.
Estimated 10yr return on Stocks
*Starting dividend yield of the S&P500-**10yr estimated average annual rate of return.Lets go in the opposite direction. During the 1990's go go years there were individuals who gave up their day job to become professional day traders. Stocks were leaping up in prices almost on a daily basis. Making money in stocks was sooooo easy. Ah...Our formula is reducing your allocation month after month as valuations diminished. Once again going against human nature.
Your neighbor who is not only 100% allocated to stocks but using margin just purchased an upscale new car for cash. Then he asks if you can take care of the family dog as they will be vacationing in Switzerland(again). Being a good neighbor of course you say yes. You go back to your house and wonder if you have lost your mind as you continue to reduce your stock exposure. To make matters worse(actually better) as stocks fly to the heavens your allocation increases aggressively into long term bonds and gold [remember this is the late 1990's]. You mention to the neighbor your buying gold and especially the precious metals mining companies. His reply is with a shrug of the shoulders and stating why would anyone purchase gold or the miners they only go down in price? "But but but" you stammer "their valuations are on the give - away - table!" To no avail he just walks back to his house shaking his head.
Fast forward to the year 2000 stocks peak with a minuscule dividend yield almost breaking below 1%! You have been long since out of stocks. Moving forward further in time to 2002 your neighbor account is not only wiped out but will take tens of thousand dollars to close due to his margin position. He files bankruptcy, long gone are the upscale cars along with the house. Wife leaves him taking the children along with his dog. Since he was a full time "professional" stock trader he now has to reenter the job market in his late forties.
That is what DYI does buys stocks, long term bonds or precious metals miners on an increasing basis as valuations improve below their average and decrease increasingly as they soar past their respective average. It is a long term strategy that is equivalent to watching your grass grow. Boring but very effective!
Updated Monthly
AGGRESSIVE PORTFOLIO - ACTIVE ALLOCATION - 7/1/16
DYI
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