Do Valuations Matter Anymore?
By some measures, valuations are off the charts. By that we mean the absurd valuations of so many asset classes in our investment pallette. And yet, despite recent corrective action, stocks continue to cling to the positive price action that has characterized a bull market that began in 2009.
If you're among those who believe valuations are, and have been for a long time, above average, if not off the charts, you might consider checking in with the esteemed John Hussman. Hussman manages money and posts monthly commentary that can be worth reading.
If you go to his website, you'll see that, in addition to managing institutional accounts, he offers mutual funds. You'll also see that his investment process includes hedging strategies you typically encounter in hedge funds, almost never in mutual funds. Hedge funds are beyond the reach of most investors (high minimums, financial qualifications based on income and net worth). On the other hand, mutual funds can be accessed by just about everyone.
I always found his hedging methods interesting, and somewhat distinctive - at least in the mutual fund universe. His commentaries would typically detail the current valuation of the the market - usually the stock market - and, if the market was what he considered "over-valued," he would note that his firm would employ more or less aggressive hedging, depending on the degree to which the market was overvalued. Sounds like an intellegent way to manage money, doesn't it?
Now, a confession: While I once read him monthly, I stopped a number of years ago, despite his obvious intelligence. Why? Simply because his investment funds' performance wasn't very impressive in the years after the 2007-2009 financial crisis. In fairness, if you were a stock investor, his funds were a good place to be before and during the crisis. In fact, during the bear market of 2000-2001-2002, they were a great place to be. But in the years after the crisis you'll witness a strangely mediocre pattern.
Question: Why did someone who did so well in the bear market of the early 2000s, and protected capital during the crisis, suddenly flop - a bit of a harsh description, perhaps, but not when you consider his previous superior performance.
You can find the answers provided by Hussman himself if you peruse his monthly commentaries. He analyzes his results with the result that he changed his investment process. We'll give you our quick and dirty understanding of what his analysis turned up and why he changed.
Simply put, his methods of valuation no longer provided good signals for determining when to apply his hedging strategies. To be clear, the facts didn't change. Overvaluation remains overvaluation. But in the past, when things got so overvalued, stock prices would drop somewhat in tandem with the degree to which they were overvalued. That stopped after the crisis. From 2009 on, the determination that stock prices were overvalued no longer mattered.
We could speculate why this is now the case. For example, is it due to the Fed's pumping so much liquidity into the system that's flowed into financial markets? Maybe the overvaluation of assets simply doesn't hamper money flowing into those assets. The liquidity produced by the Fed lowering interest rates to zero, and purchasing assets for its balance sheet (QE) overrides what in the past would have been a rational correction of prices that got to high too fast.
As a result, Hussman no longer adjusts his investment process in response to overvaluation - at least in the near-term. Long-term, valuations remain valid. They will help us understand our prospects for profits in coming years - maybe even months. Given the overvaluation Hussman finds in the stock market, the prospects aren't very good. In fact, Hussman provides data and charts that demonstrate back up his proposition that stocks could drop 65% and simply return to a normal range of valuation.
That's a pretty powerful statement, given that he's not saying that when a bear market comes (and it will), prices will not only correct, but "over-correct" to levels below average or normal. The latter would be the typical behavior of prices in most bear markets. Hussman seems to be implying that if we get a typical bear market plunge, prices would correct even more than 65%, although he doesn't come right out and say it.
Why does all this matter?
Obviously, if prices are going to go 65% south, you might want to prepare yourself either to accept the fall without panicking or to take measures to protect yourself in some way if you don't want to put up with (or can't afford to put up with) that kind of collapse.
But there's another reason this matters. Personally, this valuation puzzle has been a thorn in my side these past few years. When I consider prices to be overvalued, I've either refrained from investing in stocks, or reduced holdings. That's put a sometimes heavy lid on portfolio profits. While preserving capital should always be first and foremost, it's still nice to make money whenever prudently possible. But unless you can swallow high valuations and digest them reasonable well, your only choice has been to minimize exposure to stocks.
Fortunately, we too recognized this issue with valuations and after much reading and research found way to keep a reasonable exposure to stocks despite their seemingly high valuations.
If you're among those who believe valuations are, and have been for a long time, above average, if not off the charts, you might consider checking in with the esteemed John Hussman. Hussman manages money and posts monthly commentary that can be worth reading.
If you go to his website, you'll see that, in addition to managing institutional accounts, he offers mutual funds. You'll also see that his investment process includes hedging strategies you typically encounter in hedge funds, almost never in mutual funds. Hedge funds are beyond the reach of most investors (high minimums, financial qualifications based on income and net worth). On the other hand, mutual funds can be accessed by just about everyone.
I always found his hedging methods interesting, and somewhat distinctive - at least in the mutual fund universe. His commentaries would typically detail the current valuation of the the market - usually the stock market - and, if the market was what he considered "over-valued," he would note that his firm would employ more or less aggressive hedging, depending on the degree to which the market was overvalued. Sounds like an intellegent way to manage money, doesn't it?
Now, a confession: While I once read him monthly, I stopped a number of years ago, despite his obvious intelligence. Why? Simply because his investment funds' performance wasn't very impressive in the years after the 2007-2009 financial crisis. In fairness, if you were a stock investor, his funds were a good place to be before and during the crisis. In fact, during the bear market of 2000-2001-2002, they were a great place to be. But in the years after the crisis you'll witness a strangely mediocre pattern.
Question: Why did someone who did so well in the bear market of the early 2000s, and protected capital during the crisis, suddenly flop - a bit of a harsh description, perhaps, but not when you consider his previous superior performance.
You can find the answers provided by Hussman himself if you peruse his monthly commentaries. He analyzes his results with the result that he changed his investment process. We'll give you our quick and dirty understanding of what his analysis turned up and why he changed.
Simply put, his methods of valuation no longer provided good signals for determining when to apply his hedging strategies. To be clear, the facts didn't change. Overvaluation remains overvaluation. But in the past, when things got so overvalued, stock prices would drop somewhat in tandem with the degree to which they were overvalued. That stopped after the crisis. From 2009 on, the determination that stock prices were overvalued no longer mattered.
We could speculate why this is now the case. For example, is it due to the Fed's pumping so much liquidity into the system that's flowed into financial markets? Maybe the overvaluation of assets simply doesn't hamper money flowing into those assets. The liquidity produced by the Fed lowering interest rates to zero, and purchasing assets for its balance sheet (QE) overrides what in the past would have been a rational correction of prices that got to high too fast.
As a result, Hussman no longer adjusts his investment process in response to overvaluation - at least in the near-term. Long-term, valuations remain valid. They will help us understand our prospects for profits in coming years - maybe even months. Given the overvaluation Hussman finds in the stock market, the prospects aren't very good. In fact, Hussman provides data and charts that demonstrate back up his proposition that stocks could drop 65% and simply return to a normal range of valuation.
That's a pretty powerful statement, given that he's not saying that when a bear market comes (and it will), prices will not only correct, but "over-correct" to levels below average or normal. The latter would be the typical behavior of prices in most bear markets. Hussman seems to be implying that if we get a typical bear market plunge, prices would correct even more than 65%, although he doesn't come right out and say it.
Why does all this matter?
Obviously, if prices are going to go 65% south, you might want to prepare yourself either to accept the fall without panicking or to take measures to protect yourself in some way if you don't want to put up with (or can't afford to put up with) that kind of collapse.
But there's another reason this matters. Personally, this valuation puzzle has been a thorn in my side these past few years. When I consider prices to be overvalued, I've either refrained from investing in stocks, or reduced holdings. That's put a sometimes heavy lid on portfolio profits. While preserving capital should always be first and foremost, it's still nice to make money whenever prudently possible. But unless you can swallow high valuations and digest them reasonable well, your only choice has been to minimize exposure to stocks.
Fortunately, we too recognized this issue with valuations and after much reading and research found way to keep a reasonable exposure to stocks despite their seemingly high valuations.
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