“How Much Does the Market Have to Decline Before you Become Constructive?”

This is a question John Hussman received recently.  His answer:

“At present, a market decline of about 20% would raise our estimate of 10-year prospective returns to somewhere around 6.5% annually, which is still below-average but not intolerable. Even a smaller decline would still allow a constructive investment stance. In both cases, we would require our measures of market action to be positive: favorable trend-following measures and market internals, without hostile indicator syndromes. The problem with a shallow decline is that a constructive position would probably not be sustained for long because overbought conditions or other negative factors could emerge fairly quickly – which is what we’ve repeatedly observed since 2010.

Undoubtedly, the most favorable outcome would entail a market loss deeply in excess of 20% followed by an improvement in market internals – which is the typical way that a market cycle is completed. That would allow a good deal of latitude for the market to advance without shifting back to an overvalued, overbought, overbullish condition or some other hostile syndrome. We certainly don’t need stocks to become undervalued in order to establish a constructive position, nor do we require valuations to normalize in one fell swoop. A large improvement in valuations would be desirable, but a smaller improvement would be adequate provided that we can clear the abysmal set of conditions that we presently observe.”

I find this question interesting.  It’s one that permabears can never quite answer adequately (not that John Hussman is a permabear).  But it’s a question that has been plaguing investors for years now as they wait for that perfect 2008 moment all over again.  Many investors are convinced that if they just get one more crack at it they’ll get it right next time and buy at the lows and it will be smooth sailing. It’s a common bias that inflicts harm on many investors.  Thing is, the next time seems to perpetually evade them or when it comes, they freeze and don’t react as they wanted to.   This is one reason why I like to automate and diversify across different strategies.  This eliminates the need to ever ask yourself the above question.  After all, if you have to ask yourself the above question then you’re probably doing something wrong.

Here’s how I think of it.  The reality about investing capital is that it is a residual of what your primary production is.  If you’re productive and believe that the society you reside in will remain productive then we should expect future output and profits to increase in the future.  That should be bullish for most traditional asset classes like bonds and equities.  Human beings have an uncanny knack for making progress. In fact, I’ve argued it’s an inherent trait that differentiates us from many other animals.  Betting against this is like betting against you waking up in the morning.  It’s almost always a bad bet.  So being bearish in the very long-run is never very wise.

So, if you’re optimistic about your ability to produce and the ability of the society around you to produce then you need to design your investment portfolio around the idea that the best investment you’ll ever make is in yourself.  Any leftover is residual that should go into an automated investment portfolio of some sort (whether it be actively managed or passive) that has a long-term bullish view, but is managed in a prudent manner that aligns your overall needs with realistic targets for your monetary needs.  The vast majority of people don’t need 20% annualized returns in an investment portfolio and in fact shouldn’t be taking the risk required to achieve that.  Most investors need to maximize personal output and hedge any residual investment portfolio in a manner that protects from losing purchasing power and manages the risks in a manner that protects from the potential of permanent loss.

The bottom line is: if you spend your time worrying about catching the next falling knife to save your portfolio then you’re probably doing something wrong to begin with.


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. Well you don’t find sound analysis/advice like that very often and given out for free.My hero !

  2. Looking for value is not the same as being ‘bearish.’ Buy stocks when they are on sale; when they are not, either buy something else or wait until the next sale. There have been two firesales in the past 10 years and most likely another one coming soon.
    Yes, the vast majority of people should own low-cost, index funds, but I doubt that most readers of this blog are the vast majority.

  3. “…Human beings have an uncanny knack for making progress. In fact, I’ve argued it’s an inherent trait that differentiates us from many other animals…”

    progress and growth is a recent history, mainly influenced by a cheap and almost endless natural resource pool and by a growing population. This is changed forever. We’re resource constrained and a lot of people is figting for a shrinking resource pool. We will not be out of oil in a few years, but cheap oil, cheap corn, cheap this and that are gone. We’re entering in a totally different age and while economists are still in denial, scientists are not. This is just one of the many thought provoking pieces that is possibile to read. Most of the apocaliptyc stuff is bullshit but this is not, like other. You can go deep on this fundamental topic if you like. Just for fun… the future of the car industry seems to be electrical but it’s not because electrical batteries are not performing and will not perform in the foreseable future. There is so much optimism about the endless capacity of technology to solve everything that always amaze me. I’m an engineer and I know science and tech better than economy and I’m seeing any breaktrough in the near future while economists that don’t know how science and technology advance believe in the brightest of the possible futures. If it wasn’t dramatic it would be funny.







  4. I’ve pressed without re-reading…

    “…I’m an engineer and I know science and tech better than economy and I’m NOT seeing any breaktrough in the near future…”

  5. Pearl,

    Hussman is ALWAYS bearish. He always something he dislikes in the investment environment.

  6. too quick with the trigger . . should read “He always find something . . .”

  7. He is a fool – he was pooping all over the market in mid-2010 when his expected return was around 6%, yet now he says he would start to get interested around that level this time around. Makes no sense.

    Outfits such as Ned Davis Research don’t just run, but sprint circles around Hussman’s “analysis” – he is a FOOL for not outsourcing his market risk analysis. The cost of spending $50K on NDR versus the losing millions of client capital on wasted hedging (and frankly TIME spent generating a virtually useless weekly note) is not even close.

  8. I agree with diversify and automate but I suspect it’s difficult for some to not try and second guess the breakdown of a clearly distorted financial system.

  9. He is falling fast…20% decline? When we witnessed that in the summer of 2011 he was saying he needed to see 900spx which was another 15% below where we bottomed. He sadly has lost credibility in a big way.

  10. Good article. It is also dangerous for money managers to put a prediction on the S&P and say they will invest when it gets to that point. Why not calculate intrinsic values, discount them X for a margin of safety, and then buy/sell based on each individual equity in the portfolio.

  11. One also has to understand how “the financial system” works. And MR is only an approximation of the real model.

    A lot of folks turned bearish around 2005, 2006, 2007. But it always comes down to timing to not get wound up with giant losses.

  12. I’m a scientist, and I disagree. Okay, cheap oil is gone, but overall, quality-of-life is going to keep increasing over the next 20, 50, and 100 years.

    We’re in a commodity bubble, mostly caused by BRIC industrialization.

    Have you seen Michael Pettis’ latest piece? (Here’s a link: http://seekingalpha.com/article/869711-by-2015-hard-commodity-prices-will-have-collapsed – though I also strongly recommend his older articles, on mpettis.com).

    Past the next 10 years or so, I can see sooo many areas for innovation and growth (PV, microfluidics, MEMS, batteries, etc.). We’ll do just fine.

  13. Interesting question.

    It really frames it nicely when you think about it.

    In effect, we all essentially want to be buyers of equities, we just all need it to be on OUR terms, rather than the market’s.

    Hussman is the quintessential example of this – to the extreme.

    I think it goes to show that you have to have a whole suite of tools you can draw from to generate sound, high probability and reasoned outcomes for the future direction of market prices.

    Ultimately all of those tools begin to fail on an individual basis at some point – you need to discard them and move on to the next.

  14. Val,

    I agree. Hussman archives all of his commentaries. He is always bearish. I stopped reading him long ago. He is a one trick pony.

  15. I’m not telling you that the future is darkness but that it will vastly different than now, with much less growth in the west but, in case we will make the right decisions, a vastly better quality of life. How you measure the quality of life ? I’m sure not in terms of mere amount of consumption. It’s not just impossible because resources are limited but also stupid. There is only one resource that’s potentially unlimited, that is the amount of things to discover and study. But an energy efficent world, with less but better consumption is at least in the west a world with less economical activity and more “intelligent” leisure, much less unpayable private debt and not more. This will have an deep impact on the many financial bubbles around. Of course if will take the wrong decisions it will be darkness.

  16. I am a scientist too, and while the distant future might be quite bright, we still have to get there without hitting any big snags. That is where I think the problem is. So far, things have proceeded remarkably well, and that is because Central banks can print unlimited amounts of Fiat at zero cost to paper over gaping black holes of debt. But food and energy are real constraints, and they cannot be printed. The rate at which new technology can develop new sources probably can’t be accelerated past a certain point no matter what anyone does, and governments are not going to behave optimally in any case. We just got a few tiny tastes of what happens when those resource constraints impact real populations. When people have nothing to lose, they lose it.


    Just think of what will happen when really serious resource constraints become a regular occurrence.

  17. I dont get the obsession with Hussman other than he writes economic stuff which is a dime a dozen on the internet nowadays.

    1 year return -14.5%
    3 year annualized -5.8%
    5 year annualized -4.1%

    And people proclaim he has a great 10 year record so ignore the “short term”? (I dont consider 5 years to be short term) – his 10 year record could be beaten by the average 3 or 5 YR Certificate of Deposit (pre Ben Bernanke war on savers): +1.5%

    So he is a nice wonky read but why the attention is boggling.

  18. From CXO Advisory who tracks statements and predictions of “gurus”.

    In summary, while hedging has generally been advantageous for equity investing over the past 11 years, evidence from simple tests provides little support for a belief that John Hussman successfully times the stock market via hedging adjustments based on his assessments of market valuation and market action.

  19. He is actually good at it. The problem is predicting the path to get there.

  20. The most serious equity valuation models are based on historical data on 3 mo treasury bills, T bond and stock returns, which show an equity risk premium vs T bills (geometric) in the ballpark of 5+%/year. See, e.g., page 27 of this excellent easy to read paper:


    T bill rates are now 0.25% and the FED has made the unprecedented move of promising to hold this until 2015. so if we use a 5% estimate for the equity risk premium we get a 5.25% expected nominal return for stocks.

    So if we use the model taught in business school PE=1/(r-g) in which r is the expected return for stocks and g the expected growth rate in earnings. We see that making r=0.05 and taking g as 0%. We get a PE of 20. So even under the assumption of zero growth in earnings the stock market seems to be priced about right at this juncture.

    I have being adding WW Vanguard equities ETFs since May at a 1% rate aiming for a 30% equity exposure in 30 months rain or shine. If we get the correction Hussman talks about, I may accelerate my pace.

    IMHO, Cullen is right. A forecast free investment plan may be more efficient. Look at how I got egg on my face this year when I said at the end of 2011 that it was hard to envision positive equity returns for 2012:-)

    BTW, I am clocking 2.54% YTD with minimal equity and bond duration exposure even though I have blown away about 2% trying to short the market at a measured paced. If i had skipped shorting, i would be close to my annual goal of 5%.

    I wish I could get to 5% for 2012 in the next three months without undue risk taking. I am hope my GLD, GDX GDXJ leaps do it for me but this may remain a wish.

  21. “This is one reason why I like to automate and diversify across different strategies.” I say hogwash to your note. You wright this now, after the crash of 2000 and 2008. Would you wright this during 2000 crash and 2008 crash when every asset class went down? No matter what you held during 2000 and 2008 you lost money. Give me a scenario where you did not lose money during these crashes, then coma back to me. I lost a lot of money believing in asshole financial advisors to “diversify.”

  22. Depends on how you’re diversifying. Are you diversifying through negatively correlated strategies and assets? Diversification doesn’t mean holding similarly correlated assets. Though most people think that’s what it means….