Gyroscopic Investing

Tyler wrote: Hussman is a reliable permabear.  It's when he predicts great market growth that you know we're truly in uncharted waters. 

Gosso wrote: All of Jesse's work is great and I highly recommend it, although a strong cup/pot of coffee might be needed to get through a few of his longer posts.

http://www.philosophicaleconomics.com/2014/06/sixpercent/ wrote:Now–and this is the key takeaway–every single forecasting method in existence that purports to use valuation to accurately predict point-to-point equity market returns in U.S. historical data exploits this same trick.  The data set that we’re working with, covering the U.S. equity market from 1871 to 2014, contains significant variability in the average valuations and average rates of return that it exhibits.  That variability can be dampened by limiting the analysis to very large time horizons and by using Shillerization, but it can’t be eliminated. It’s been especially pronounced in the last two decades, with valuations having migrated to what might otherwise be described as a “permanently high plateau.”?  Given this migration, any model that attempts to predict returns in the data set on the basis of a normal rate of return is bound to produce significant errors, even when the returns are Shillerized.  The only way for the predictions of the model to fit with the actual results in the presence of the errors is for the errors to cancel.  When you see a tight fit, that’s always what’s happening.

When a person sits behind a computer and sifts through different configurations of a model (different prediction time horizons, different mean valuations, different growth rate assumptions, different date ranges for testing, etc.) to find the configuration in which the predictions best “fit”? with the actual subsequent results, that person is unwittingly “selecting out”? the configuration that, by chance, happens to best achieve the necessary cancellation of the model’s errors.  The result ends up being inherently biased. For this reason, we should be deeply skeptical of models that claim to reliably predict returns in historical data on the basis of successful in-sample testing.  We should judge them not by the superficial accuracy of their fits (an accuracy that is almost always engineered), but by the accuracy of their underlying assumptions.

Mean-reversion methods make the assumption that non-cyclical valuation metrics will eventually fall from their “permanently high plateaus”? of the last two decades down to their prior long-term averages–with respect to the the Shiller CAPE, the assumption is that the metric is going to fall from 26.5 to 17.  Is that assumption going to prove true? Forget the curve-fits, forget the backtests, forget the data-mining, and just examine the assumption itself.  If it’s going to prove true, and if the normal return would otherwise be 6% real, then the actual return will be 1.4% real. If it isn’t going to prove true, then the return will be something else.

...

Now, to be clear, I’m not saying that valuation doesn’t matter.  Valuation definitely matters–its power as a return factor has been demonstrated in stock markets all over the world.  Holding other factors constant, if you buy cheap, you’ll do better, on average, than if you buy expensive.  This is true whether we’re talking about individual stocks, or the aggregate market.

What I’m taking issue with is the notion that we can use valuation to build “historically reliable”? prediction models whose specific predictions closely align with actual past results, models that give us warrant to attach special “scientific”? or “empirical”? privilege to our bullish or bearish opinions.  That, we cannot do.  Given the significant variability in the historical data set, the best we can do is mine curve-fits whose errors conveniently offset and whose deviations conveniently disappear.  These are not worth the effort.

In the end, valuation metrics are only capable of giving us a crude idea of what future returns will be.  In the present context, they can tell us what we already know and accept: that future real returns will be less than the 6% historical average (a perfectly appropriate outcome that we should expect at equilibrium, given the secular decline in interest rates and the below-average implied returns on the assets that most directly compete with equities: cash and bonds). But they can’t tell us much more. They can’t arbitrate the debate between those of us who expect, say, 3% real returns for U.S. equities going forward, and who therefore judge the market to be fairly valued (relative to cash at a likely negative long-term real return), and those of us who expect negative real returns for equities, and who therefore find the market to be egregiously overvalued.  The reason valuations can’t arbitrate that debate is that they don’t reliably mean-revert.  If they did, we wouldn’t be having this discussion.

MachineGhost wrote: To quote Bill and Ted, "Excellent!"

babysquirrel wrote: To quote Bill and Ted, "Excellent!"
Actually that was Wayne and Garth there Mr. Know-It-All...

babysquirrel wrote: To quote Bill and Ted, "Excellent!"

Actually that was Wayne and Garth there Mr. Know-It-All...

Bill: Ted, while I agree that, in time, our band will be most triumphant. The truth is, Wyld Stallyns will never be a super band until we have Eddie Van Halen on guitar.

Ted: Yes, Bill. But, I do not believe we will get Eddie Van Halen until we have a triumphant video.

Bill: Ted, it's pointless to have a triumphant video before we even have decent instruments.

Ted: Well, how can we have decent instruments when we don't really even know how to play?

Bill: That is why we NEED Eddie Van Halen!

Ted: And THAT is why we need a triumphant video.

Bill, Ted: EXCELLENT!

[air guitar, the clock chimes 8:00 am]

Bill: Uh oh, we're late!

Ted: For what?

Bill: For school, dude!

Ted: Oh yeah.

I Shrugged wrote: OK, the Hussman calculus goes to what I was mentioning a few weeks ago.  With only half of the PP assets being of a type that beats inflation in the long run, and with the yields and prices being what they are, there is no way in heck a PPer should be counting on more than about 2% real over the coming years.

I Shrugged wrote: Gold matches inflation.  "You can buy the same suit" and all that.  How can it be otherwise, other than for shorter term ups and downs?
Cash matches inflation over the long term, according to studies by, or published by, John Bogle.
Both make perfect sense to me.

I Shrugged wrote: OK, the Hussman calculus goes to what I was mentioning a few weeks ago.  With only half of the PP assets being of a type that beats inflation in the long run, and with the yields and prices being what they are, there is no way in heck a PPer should be counting on more than about 2% real over the coming years.

ochotona wrote: 2% real return would be better than another late 2008 - early 2009 scenario, especially for someone near or in retirement.

Alanw wrote: Being in retirement, it is difficult trying to decide asset allocation to have some income but not risk principal reduction. Your basic choices are stocks, bonds, cash and hard assets. None look real enticing at the moment. If you don't like gold, maybe real estate.  Go all cash and hope for deflation?  Bonds may be in a bubble?  Stocks overvalued?  Maybe just hold your nose and spread across all asset classes. Like everyone else, I'm not sure what to do. But I guess that could be said about any other point in time.

Alanw wrote: On the bright side, I have assets to work with. Some folks in or nearing retirement may have much larger issues.

sophie wrote: In another thread someone mentioned that the direction of the stock market after 2008 was "obvious".  Well, it wasn't obvious - many people were terrified of the market and there were predictions that it would continue to drop, not recover for decades, etc. 

stuper1 wrote:

I Shrugged wrote: OK, the Hussman calculus goes to what I was mentioning a few weeks ago.  With only half of the PP assets being of a type that beats inflation in the long run, and with the yields and prices being what they are, there is no way in heck a PPer should be counting on more than about 2% real over the coming years.

Do you have a better recipe to suggest?

I Shrugged wrote:

stuper1 wrote:

I Shrugged wrote: OK, the Hussman calculus goes to what I was mentioning a few weeks ago.  With only half of the PP assets being of a type that beats inflation in the long run, and with the yields and prices being what they are, there is no way in heck a PPer should be counting on more than about 2% real over the coming years.

Do you have a better recipe to suggest?

I do not.

dragoncar wrote: I'm adding a 5% tilt towards Cinnamon, but Nutmeg is probably a good choice too.  Covers the famine condition.