Let me tell you a story. (I shared this a decade back, but it fits well with today's post so I'm using it again. It's likely most of you weren't SMIers 10 years ago, but even if you were, who can remember that far back?)
In 1999, I watched with amazement as some of the dot.com stocks rose to breathtaking price levels when they had no earnings and no hope of having any earnings for several years. The ones that did have miniscule earnings had P/E ratios that went to 200, then 300, then 400 and more. It was insane.
I decided to cash in on the insanity by selling short two of the high flyers, profiting when the inevitable bursting of the bubble took place. But I didn’t put a plan in place. I was so sure that “they just couldn’t keep going higher” that I didn’t bother with stop losses or any of the other aspects of a plan that I regularly apply elsewhere.
I was way wrong. They did keep going higher. I was overly confident, not knowing at the time that the limits of the mania were far more elastic than I had ever imagined. I finally couldn’t take it anymore and got out. The losses weren’t devastating, but they were painful, embarrassing, and much more than they would have been if I had followed my usual guidelines.
To add insult to injury, the mania ended the very next week after I got out! (It almost seems as if the market taunts you sometimes, doesn’t it?) My analysis was correct; my timing—driven by my emotions—was terrible. If I had the courage of my convictions and hung in there, I would have cleaned up over the next year as the tech crash unfolded.
Lesson #1: Don't anticipate the future. The trend is your friend.
Lesson #2: Always have a plan in place that will force you to correct your errors. Even when you know you’re right. Especially when you know you’re right.
With those lessons in mind, let's visit the latest commentary from fund manager John Hussman. We have a lot of respect for Hussman's smarts and research capabilities. But his style of forecasting, which has resulted in bearish views for most of the past decade, has led him astray.
His flagship fund, Hussman Strategic Growth, has underperformed the S&P 500 for eight of the past 10 years, most recently by the rather stunning margins of 28% in 2012 and 39% in 2013. And his more conservative Hussman Strategic Dividend Value is dead last in this month's FPR in its peer group.
He candidly admits to having been out of step with the market:
In the market advances that culminated in the 1929, 1972, 1987, 2000 and 2007 pre-crash peaks, a combined syndrome of overvalued, overbought, overbullish conditions emerged in each instance. These syndromes can be defined in numerous and largely overlapping ways, but in general, once these syndromes appeared, steep market losses typically followed in fairly short order. In instances where they didn’t, the syndrome was usually a one-off outlier driven by a short spike in bullishness. Still, in no case did one observe repeated, increasingly severe overvalued, overbought, overbullish syndromes persisting entirely uncorrected and without consequence.
The fact that there have been no historical exceptions to this pattern prior to the recent half-cycle has posed quite a challenge for us in recent years....
In any event, it’s fair to say that valuations could go higher still, and we can’t rule that out. Historically, the emergence of similarly extreme overvalued, overbought, overbullish syndromes (as we also observed in 1929, 1972, 1987, 2000 and 2007) would suggest that the possibility is negligible – but we’ve been punished for our knowledge of history in this cycle.
I sympathize. Hussman relied on historical norms (as did I), was certain he was right (as was I), and has paid a price for being wrong (as did I). I, however, bailed out of my positions and not only missed the opportunity to eliminate my losses but very handsome gains as well. Hussman has had the courage of his convictions and has stayed the course. I give him an A+ for self-discipline in what has surely been a painful couple of years for him.
Eventually, of course, he will be proven correct. Every bull market is followed by a bear market, and when that happens, it seems quite likely that his funds will be the stars of the show. The problem, as always, is one of timing, isn't it? As John Maynard Keynes pointed out, "The market can stay irrational longer than you can stay solvent."
We continue to preach: Stay with your plan. You may be thinking, "Wait, John Hussman has stayed with his and gotten killed. Doesn't seem like it's always a good idea to stay with the plan." True enough, depending on the plan. Hussman's plan was based on his correctly anticipating the future course of events. When the market didn't behave as expected, he was at its mercy.
The strategies SMI suggests do not rely at all on forecasting skills or our market expectations. They are based on momentum and trend-following—when those change, so do our recommendations. They reflect the lessons learned in the story of my dot.com speculations.