Interdum stultus opportuna loquitur...

Monday, August 23, 2004

Remember "20 is the right number"?

Note - from June 24th 2009, this blog has migrated from Blogger to a self-hosted version. Click here to go straight there.

You might recall that in one of my "eponymous" columns back in the olden days, I wrote something about the folly of buying US equities anytime the market had a price-earnings ratio above 20 (based on trailing earnings).

The short answer was (and is) that when the market has a PE of over 20, the average ten-year holding return was negative.

I have long respected John Hussman, who runs a fund in the United States. His basic idea is that you find a bunch of good stocks and build a portfolio - much as the IWL team did (and does)... using a highly "value oriented" approach.

Then, when the "market climate" is "unfavourable" - that is, in addition to fundamental market-wide over-valuation, you also have rising bond yields and a technically unfavourable condition - Dr Hussman hedges away market risk by holding put options over the S&P500.

So Dr Hussman partitions the investment environment in 2 directions; whether or not the market as a whole has "investment merit", plus whether or not the market has speculative merit. When the market has both, you invest broadly and unhedged. When the market has neither you invest very very selectively and you hedge away market-wide risk. A very sensible approach indeed - plus he writes very well. He and David Fleckenstein are about the only two "long only" managers that I would listen to (apart from Sir John Templetom, of course).

Dr Hussman's primary contribution to my wisdom, is the idea of comparing price to peak earnings; that is, rather than comparing the marlket's price to the most recent 12-month trailing earnings, he uses the highest level of earnings achieved by the market. This is a (sensible) attempt to smoothe the volatile movements in earnings going into (and coming out of) recessions.

His latest work reinforces the stuff that I did using "raw" price-earnings ratios; in short, when the market's price to peak earnings ratio is above about 15, you are unlikely to get a return that compensates you for inflation (you have to bear in mind that the "post 1950" numbers include a period of massive inflation - the 1970's - which skews returns upwards in nominal terms).

Looking at the table below, it is pretty clear that the current market is characterised by distinctly unfavourable investment merit. As such, folks have to be incredibly selective about what long positions they hold in equities, and should be on the lookout for periods of unfavourable technical or "speculative" environment.

2-yr return (%p.a.)

10-yr return (% p.a.)


























Final note: The market's not closed yet, so this is not the "standard" Morning Rantola.

I am a little concerned about the market's failure to hold 1100 today; there was a re-test of the early high (1101.50 in the S&P futures) on persistently high values of TICK (indicating that the market was getting more than the usual "push" to try and generate some short-covering).

Also, the NDX got right to a target that I nominated (in an e-mail to my chums, Timbo and Mav) at 1380 (the high for NDX futures was 1079.50) and then turned "shouth" (that's my best Greek accent) in a big way.