This post is a construction of two distinct pieces; first I'll provide a single paragraph from a post from Ahhaha's thread excerpted from a discussion between ahhaha and a poster who found the perfect set up for a trade, (link to complete reply post Message 23102369 )
What follows next; is the most important part of this post;
StreetSmart71 says; It is why I'm so determined that this set up is PERFECT.
Ahhaha Replies; Uh oh. You have to look for things that aren't perfect, things that are uncomfortable, because otherwise others will be trying to exploit the apparent potential too, and in their attempts they cause things to occur as seen in your perception that the puts are overvalued. Mostly, you have to seek risk, not avoid it. It is an axiomatic fact that risk is proportional to return. Are you trying to navigate around axiomatic truth? If so, good luck.
Now with the above in mind, Ive copied a part of a Post from a letter by a prominent fund manger below; The piece itself characterizes this fund managers views about which the context of this fund managers performance is contrast to the overall market. I know little or nothing of this fund or its historical facts, but I can say this about these seemingly disparate pieces. Ahha suggests that an axiomatic truth of market performance is too seek risk, not avaoid it. While the piece below seemingly characterizes this fund manger whose major goal seems to be to cancel risk by using constructs in opposition to one another, this is popularly known as hedging away risk.
I believe in Logic; and further Logistics adopted by systems to purpose. I ask you when reading below does this summary letter constitute a logical approach to axiomatic risk?
You be the judge, I'll be happy to summarize thoughts you have in another post, feel free to reply via SI PM or Yahoo email..
Link to full article here its too long and graphics are missing so Intro portion copied below;
hussmanfunds.com
December 18, 2006
Performance Notes, Ouija Boards, Bollinger Bands, and Valuations
John P. Hussman, Ph.D.
All rights reserved and actively enforced.
While our returns in the Strategic Growth Fund have been positive in recent months, they've clearly been uninspiring. Our risk-managed, value-conscious investment approach has been out of sync with the major indices. There are two factors at work here. First, since the market's May high, our stock selections haven't outperformed the S&P 500 or Russell 2000 (as they have generally done over longer spans). That certainly happens from time to time, but the effect feels magnified when it happens in a period where we're also hedged and the market moves higher over the short-term.
Even in the broad market, we're observing a sharp drop in the number of individual stocks outperforming the S&P 500, while at the same time, the proportion of outperforming stocks having low quality ranks (as rated by S&P) has increased.
Second, over the past 10 weeks or so, the market has reflected overvalued, overbought, and overbullish conditions (a combination that has historically been associated with market returns below Treasury bill yields, on average – though not in every instance). During this period, we've been willing, even eager, to accept a material speculative exposure to market fluctuations (using call options), provided we observe a sufficient pullback to clear that overbought condition without major deterioration in internals. We haven't yet observed a pullback of even a few percent over these weeks.
While the Strategic Growth Fund does have enough call options presently to reduce our hedge by about 40% in the event of a substantial continued advance (they currently provide us with a 10-15% exposure to market fluctuations), that position still amounts to only about 1% of assets. In the event of a substantial market pullback (say, a few percent), the value of those existing calls would be expected to decline. If market internals were still intact at that point, I would be inclined to increase the position on such weakness toward about 2% of assets, which would provide good exposure to any market advance that might begin from that lower base.
In any event, the upshot is that by adhering to a stock selection and hedging approach that has achieved strong returns with reasonable risk over the long-term, my efforts have achieved abysmally low returns in a rallying market over the short-term.
There are a few possible responses to this. One would be to abandon an approach that has a strong basis in both theory and evidence, and align ourselves with “what's working right now” – basically lifting our hedges and increasing our exposure to low-quality speculative stocks that are on the move. This is a recipe for disaster. You can't imagine my personal despair when a friend and client, pleased with his long-term performance but exasperated by my avoidance of the “glamour” tech stocks in late-1999, moved his retirement account to E*Trade, assuring me that he was only going to invest in “solid” techs like Lucent, Cisco, and Sun Microsystems. He was convinced that the tech boom had created a new economy. “We need to be a part of this.” I imagine he lost the bulk of his carefully built retirement wealth over the following two years.
A second response would be to close our ears and hum, adhering to our existing approach without any effort to adapt to possible changes in financial relationships. Again, that's not an acceptable approach. Especially since research is our strong suit.
So on any given day, what I'm actually doing is running variations of stock selection approaches on historical data – for example, testing the effectiveness of using operating P/E's, earnings momentum, etc. What I find is that the best performing approaches, even over the past decade, are those that emphasize normalized free cash flow, and are conscious of both valuations and market action. What I also find is that the versions that have performed best over the long-term are lagging this year, and that it's difficult to improve on our existing methodology. That's frustrating, but also somewhat comforting.
I also spend part of each week reading and listening to the arguments advanced by Wall Street analysts, and then going to the data to test them. These arguments include the Fed Model, the advocacy of price/operating earnings ratios, supposed links between earnings growth and market returns, arguments that the end of a Fed tightening cycle is quickly favorable for stocks, etc. Most of the current bullish arguments, unfortunately, are devoid of factual historical evidence. For example, while earnings growth and stock prices have a reasonable relationship over the long-run, the correlation between earnings growth and market changes on a year-to-year basis is roughly zero (actually slightly negative). And as I've noted before, when the price/peak earnings multiple for the S&P 500 has been 16 or higher (the current multiple is over 18), we find that the S&P 500 has experienced a loss, including dividends, averaging -6.5% over the 18-month period following the final hike of a Fed tightening cycle.
Ouija Boards
In both stock selection and market analysis, my essential requirement is that any approach I apply to actual Fund management has to have a mechanism – an understandable, theoretically sound reason why it should perform well over time (preferably based on the definition of a security as a stream of discounted cash flows), and it should achieve good returns with acceptable risk over a variety of independent sub-periods of history.
Martin Zweig once said that he would follow a Ouija board if it worked historically. I wouldn't. The reason is that if you're investing people's retirement wealth, college funds, or long-term savings, you'd better be sure you know exactly why what you are doing ought to work over the long-term. Because if you're just using a Ouija board, and the market starts going against you for some period of time, you're stuck – either you continue to follow something when you have no idea why it should work in the first place, or now you've got to find something else that works even though you don't understand why. In the end, you'll have neither confidence nor discipline.
It's exactly because our approach is grounded in both theory and historical experience that we can maintain confidence and discipline during admittedly uncomfortable periods like this. Over the full cycle, the market recognizes reasonably-valued stocks that throw off a reliable stream of cash to shareholders (especially those that exhibit enough investor sponsorship so that future cash flows aren't called into question on the basis of others' information). Over the full cycle, rich valuations revert to more appropriate levels. And even over the intermediate-term, overbought markets correct at least moderately.
Ultimately, it will be good to break out of this range. It may be a few weeks or even months, but meanwhile, my focus will continue to be research, and following a consistent set of actions that has historically achieved strong results. In most professions, outcomes tend to be closely related to effort and skill. While that's not generally true over the short-term for investment management, it still tends to be true over the full market cycle.
For Balance of article with supporting graphics click above link;) |
