http://www.hussmanfunds.com/wmc/wmc081020.htmOctober 20, 2008
Why Warren Buffett is Right (and Why Nobody Cares)John P. Hussman, Ph.D.
The best way to begin this comment is to reiterate that U.S. stocks are now undervalued. I realize how unusual that might sound, given my persistent assertions during the past decade that stocks were strenuously overvalued (with a brief exception in 2003). Still, it is important to understand that a price decline of over 40% (and even more in some indices) completely changes the game. Last week, we also observed early indications of an improvement in the quality of market action, and an easing of the upward pressure on risk premiums.
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Why Warren Buffett is right, and why nobody cares On Friday, Warren Buffett published an editorial in the New York Times titled “Buy American. I Am.†In that piece, Buffett noted “ I've been buying American stocks. This is my personal account I'm talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities. Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky's advice: ‘I skate to where the puck is going to be, not to where it has been.'â€
The most interesting thing about that op-ed piece wasn't Buffett's opinion about stock valuations. He's absolutely right, in my view. Rather, it was fascinating how quick many investors were to dismiss Buffett's advice, saying either that he didn't understand how bad the economy was going to get, that he preferred to “get in early,†or that he was “talking his book†and trying to bid up the value of his own investments. Look. Buffett doesn't need the money. Virtually everything he has is now or will ultimately be committed to philanthropy. My impression is that Buffett honestly doesn't like to see investors making decisions that will damage their financial security over time. Also, a good part of his own self-concept centers on being a good allocator of capital. If he didn't like his investment positions, he wouldn't try to talk them up. He would liquidate them. If he thought he could postpone his purchases without a high probability of missed returns from waiting, he would have waited. My guess is that Buffett is very excited about the values he has been buying up, but doesn't get wrapped up in the day-to-day fluctuations that weaken the judgment of less disciplined investors.
The most expensive resource on Wall Street is short-term comfort. Investors who constantly seek comfort over the short-term ultimately give up a fortune over the long-term. In a market economy, the most reliable source of long-term gains is to provide scarce and useful resources to others when those resources are most in demand. At present, the most probable source of long-term returns is the willingness to provide liquidity (holding out willing bids at depressed prices in a panicked market), risk-bearing (taking on the market risk being liquidated by fearful or distressed sellers), and information (through the proper assessment of value). In my view, Buffett's willingness (and our own) to accept market risk here does all three.
Though Buffett doesn't easily show his hand regarding individual purchases or the details of his calculations, he has always been very clear about what drives his assessment of value: stocks should be valued as if you were purchasing the whole business. The way you (properly) value a business is to weigh the price against the long-term stream of cash flows that you expect that business to deliver into your hands over time.
The real object of interest is the long-term stream of cash flows that the company will deliver into the hands of shareholders over time (beware of companies that quietly dispose of their reported earnings through grants of stock and options to management and employees). Nearly all of the value of a stock is loaded into the “tail†of that stream – 5, 10, 20 years out and beyond. As Buffett notes “fears regarding the long-term prosperity of the nation's many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.â€
The rush to dismiss Buffett's advice underscores the extreme level of bearishness among investors here. According to Investors Intelligence, just 22.4% of investment advisors are presently bullish. This matches the lowest extremes we've seen in decades. Extreme negativity of investors has generally been a useful contrary indicator of stock market prospects. That doesn't ensure that stocks have registered their final lows, but it contributes to a set of historically favorable conditions here.At present, we observe not only undervaluation coupled with negative sentiment, but also extreme volatility that has historically accompanied important market troughs. Similar spikes in actual (e.g. 44-day) volatility were observed in July 1962, June 1970, October 1974, December 1982, December 1987, October 1998, and September 2002, all which were associated with important market lows.
The argument for gradually increasing our stock market exposure in the past couple of weeks is not that some flag has gone up that provides certainty about a bottom. Rather, our investment discipline is to gradually increase our investment exposure in proportion to the expected return/risk profile associated with prevailing conditions of valuation and market action. Scaling our positions in proportion to the market's expected return/risk profile, based on prevailing conditions (rather than trying to forecast market turns), is the essential practice.
Buffett notes, “Let me be clear on one point: I can't predict the short-term movements of the stock market. I haven't the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.â€
I have no idea whether the market will be higher or lower a month or a year from now either, but I think I differ from Buffett on the reasons for this. Buffett's reason is that he largely disregards short-term fluctuations, understanding that the market will improve before visible fundamentals do. My reason is that our market allocation is proportionate to the favorable expected return/risk profile of the prevailing Market Climate, and I have no way of knowing when that Climate will shift. When it does, we'll change our allocation. As I've said before, you don't have to forecast the future direction of the wind – you just need to regularly adjust the sails as the evidence changes.
Early measures of market action turn favorableNotably, last week we observed a measurable reversal in risk premium pressures, coupled with a clear “breadth reversal†across a wide range of industries. As I've stated frequently over the years, the most important feature of market action is not the extent or duration of market movements, but their quality and uniformity. These measures can change very quickly, and long before “trend following†signals such as moving-average crossings occur. Last week, our most sensitive measures of market action clearly reversed to a favorable condition. These don't “whipsaw†very often because they come into consideration only when market action is unusually compressed. Presently, in addition to undervaluation and extreme sentiment, we already have the beginnings of favorable market action.
That said, we don't yet have enough evidence to simply remove our hedges. The prevailing evidence is consistent with a high expected return/risk profile for stocks, but the still “early†improvement in market action and the unusual nature of the current downturn suggest that we maintain something of a “stop loss†in the form of continued put option coverage, with strike prices within a few percent below current levels. That is the position that we have established here.
The recent panic is frequently described as the “worst†since the Great Depression, but this does not imply that the outlook is similar. One of the clearest contributors to the Depression was the failure of the monetary base to expand at anywhere near the demand for base money. At present, governments have made a concerted effort to put the world awash in base money.
Neither the crisis in financials or the current recession are surprising, but Depression talk is hyperbole. About the only surprise in recent weeks was that the broad recognition of a U.S. recession emerged at the same time as the peak of the financial crisis. That compressed what should have been two separate down-legs of a bear market into a single swan-dive. This downturn is certainly extreme, but the conditions that amplified the downward spiral in the Great Depression are largely absent here. Both at market peaks and at market troughs, investors allow their imaginations to run, almost always to their detriment.
I'll repeat what I wrote during the 2000-2002 bear market: at meaningful market lows,
"the tenor of news reports has always been something to the effect that 'conditions are bad, expected to get worse, and there is no end in sight.' When the news reports are uncontroversial in reporting that the U.S. is in recession, when they suggest that there is worse news ahead, and when they indicate that nothing seems to be helping, that is when the market is likely to register its low." ....................
For 74 and 99, he was early by some 3 to 6 months which is very decent for medium to long term investors. But guess this wouldn't work for traders whose perspective is as short as hours. Of course, remains to be seen for this call how long the duration before the mkt really takes off - days, weeks, months, years, decades...?
