Investing Process

John Hussman had a couple of interesting tidbits in this week's commentary that are worth exploring.

Hussman focuses a lot on valuations as determining likely returns over the next ten years. If valuations are high then expected returns are likely to be low calling for a more defensive posture and if valuations are low then then expected returns would be higher calling for a more invested posture. This approach has generally resulted in the fund not looking very much like the S&P 500. At times this result is good and at times not.

First up;

I do expect that greater prospective returns are possible from investment strategies with the flexibility to vary their market exposure and asset allocations over time.

This ties in with what I believe in although I have to say I came to this before I started reading Hussman. I've attributed my belief in using the 200 DMA to reduce exposure to an article by James Stack in Smart Money Magazine in 1993--back then Hussman was more known for options commentary in the back of Barron's.

Throughout the industry there are various biases and other obstacles that prevents more attention being given to this but if the stock market is at greater relative risk of going down a lot we are far more likely to have success simply getting out of the way than trying to pick stocks that can somehow go up as the market falls 30%.

One observation on Hussman to this point is that his process seems to place more emphasis, in terms of implementation, on valuation such that stocks can go up a lot even when valuations are high, causing him to be underinvested, which is what has happened lately which is something Hussman has lamented a couple of times in past commentaries. My own take is that this is a forest for the trees sort of thing and I think there is more utility in acting on what the market is doing (SPX above its 200 DMA as a measure of healthy demand for equities) not what it should be doing.

The other quote;

So the challenge - and success strategy - for investors will be to accept much less exposure to market risk when it is priced to achieve poor long-term returns, and to expand their exposure to market risk when it is priced to achieve strong long-term returns.

As indicated above I think more success can be had with a more direct cause and effect type of indicator. There have been periods where the market stayed cheap for years and other periods where it stayed expensive for years. This is why I have focused on "less exposure to market risk" based on more technical indicators. If the S&P 500 is going to drop 50% then long before that low it will breach its 200 DMA. And yes some 200 DMA breaches will turn out to be insignificant but this is much easier to be disciplined about and in my opinion far less fuzzy than fundamental valuations.

Hussman's fund has done a great job of avoiding the full brunt of down a lot but unfortunately it misses too much up a lot. From the March 2003 low to the October 2007 high the SPX was up 80% and HSGFX was up 32% (taken from Google Finance so does not include dividends). From the March 2009 low the SPX is up over 100% and HSGFX is down 2% (taken from Google Finance so does not include dividends).

To paraphrase from past posts; Hussman offers very important bits of process to take in to contribute to building your own process but ultimately we all need to create our own process or hire the job out.