What is risk, first of all? When describing risk to a client I would say, the historic returns for this investment over a certain time period are this number. The relevant index for the same time period resulted in this number and the potential for a different number, higher or lower, is the 2X standard deviation number, normally a big number. The larger the standard deviation, the higher is the range of potential returns. What Hussman does is reduce the expected returns to the typical outcome associated with the conditions observed in the economy at this point in time, and includes a range of other possible outcomes as well. Here is more from the Hussman article described earlier...
Unfortunately, a wide range of possible outcomes necessarily implies, well, a wide range of possible outcomes. Some of those can be quite bad, but some can be quite good. Still, if the average expected outcome is poor, we'll forego the possibility of those quite good outcomes in order to avoid the quite bad ones. That can be difficult during periods when speculative (and even dangerous) risk is temporarily working out nicely, while we're standing defensive. But long-term returns are based on repeated discipline, not single hits or misses (emphasis added) (except for investors who take excessive risks that wipe them out).
What produces strong risk-adjusted returns over a complete market cycle is to accept more risk, on average, when the return per unit of risk is likely to be strong, and avoid risk, on average, when the return per unit of risk is likely to be weak.
So when will we accept more risk? Easy – when the expected return from accepting risk increases, or when the expected range of outcomes becomes narrower. Presently, two things would accomplish that. One is clarity, the other is better valuation.
This discussion is in contrast to the sage advice of buy and forget. Here we are reading that looking for entry points based on observed conditions that include attractive price (valuation) and/or the reduction of threats (clarity) to investors getting the return of their capital, at the minimum, plus some reward for their risking that capital. So it is different than market timing in that we are not looking for a target price to initiate a trade, but rather we are looking for certain conditions to exist and there may also be a reflection of that in the market price that supports the observations.
John Hussman continues in his article about his current observations being worrisome and describes his current tolerance for risk. This could also be a description of his outlook for 2010.
As we learned from the various bubbles of the past decade, discounting a risk means more than simply paying lip service to it. Major risks are not discounted by talking about and dismissing them. Risks are discounted when it is taken for granted that they will get worse. Positives are discounted when it is taken for granted that conditions will continue to improve. From my vantage point, we are much closer to having fully discounted the positives than we are to even scratching the surface of the second wave of negatives.
From current valuations, durable market returns appear very unlikely. As I noted last week, whatever merit there might be in stocks is decidedly speculative. That doesn't mean that the returns must be (or even over the very short term, are likely to be) negative. What it does mean is that whatever returns emerge are unlikely to be durably positive. Market gains from these levels will most probably be given back, possibly very abruptly.
Still, we will get to the other side of these uncertainties, many of them within months, not years. I expect that we'll resolve the “two data sets” issue as we move through 2010, which itself will narrow the range of possible outcomes and – especially if valuations come in – allow us to accept greater amounts of market risk in response to improvements in valuations and market action. As an optimist and a realist, I've had to play the realist much more in recent years. I don't expect that it will ever be appropriate to abandon that realism, but I'm looking forward to much greater optimism as we move through 2010.
Without any question, I share his level of concern, with a significant difference. He does not acknowledge here in his article that the Federal Reserve and US Treasury are hell bent on doing whatever is necessary to prevent a second major economic collapse. Despite a great deal of skepticism about their ability to do that, given the international complexities in addition to the domestic issues, it seems foolish to me to overlook the determination they represent, as well as the keys to every vault and the printing presses. The power they have available to them is probably unconstitutional it is so expansive, but that is simply a technical question for the courts to wrestle with when the dust settles. They could conceivably be at least partially able to reflate the economy. The probability for sustainable results is impossible to describe since there is no clarity about how it could be orchestrated. What do you think? Scanner