“Everything, including the market, is ultimately empty of a separate self. One market can only be understood and analyzed in the context of other markets and conditions. Supply and demand, in particular, should not be considered in isolation.”
Long time Outside the Box readers are quite familiar with Dr. John Hussman, as he is a frequent choice for this column. But this week I think he has written one of his bests essays ever. He cleverly weaves in quotes from a Zen master who is his friend and gives us a very fresh look at market analysis. This is a thought piece and you should set aside some time to absorb the lessons. You will be well rewarded.
Dr. John Hussman is president of Hussman Investment Trust. You can find out more about the mutual funds he is involved with at http://www.hussmanfunds.com/.
And I recorded three sessions for Yahoo Tech Ticker in New York this morning. You can go to Yahoo and see them.
John Mauldin for Outside the Box
Zen Lessons in Market Analysis By John P. Hussman, Ph.D.
“The best way of preparing for the future is to take good care of the present, because we know that if the present is made up of the past, then the future will be made up of the present. All we need to be responsible for is the present moment. Only the present is within our reach. To care for the present is to care for the future.”
This week’s comment is dedicated to my dear friend Thich Nhat Hanh, a Vietnamese Buddhist monk who was born on October 11, 1926, having been born previously in January of that same year, and twice again about 25 years earlier, not to mention countless other times through his ancestors, teachers, and other non-Thich Nhat Hanh elements. Thay (the Vietnamese word for “teacher”) would simplify this by saying that today is his eighty-third “continuation day,” because to say it is his birthday is not very accurate.
If the quote at the top of this page looks somewhat familiar to our long-term shareholders, it may be because the practice of tending to the present moment – responding to prevailing conditions rather than relying on forecasts – is central to our investment discipline.
Focusing on the present moment doesn’t imply ignoring the past or failing to consider the future. It’s clear, for example, that we put a great deal of attention on estimating future cash flows and discounting them appropriately in order to evaluate whether various investments are priced to deliver satisfactory long-term returns. We certainly devote our attention to macroeconomic pressures and latent risks that threaten to become full-blown crises later. Still, we rarely make near term forecasts. Nor do we answer surveys like “where do you think the S&P 500 will be at year-end?” – a question that falls entirely outside of our way of thinking – like asking Columbus what sort of trees he thinks are planted along the edge of the Earth. The reason we avoid forecasts, very simply, is that they are not required, and that they can be a hindrance.
One of the major debates among investors is between buy-and-hold investing and market timing. Think of the market as a big hat that has both red and green marbles in it, red corresponding to declines, and green corresponding to advances. The buy-and-hold investor essentially believes that it is impossible to predict which color marble will be drawn next, but that on average the marbles will be green. So the buy-and-hold approach simply holds on, regardless of prevailing conditions. The market return expected by a buy-and-hold investor is the “unconditional expected return” – something that has historically been about 10% annually. Let’s call this E[R]
In contrast, a forecaster does believe that the next draw can be predicted given some information “X”. As that information varies, forecasters will decide to buy or sell. But forecasters typically do something extra. Generally speaking, forecasters are not content with dealing with the present moment, and instead are prone to making bold forecasts about the next month, quarter, year, or even an entire stream of future returns (bull markets and bear markets).
The problem with this, in our view, is that it implicitly assumes that the information set “X” will remain constant. Worse, the size of the forecasts is generally far too large to be rational. A good forecast is most often a humble one.
Robert Hall of Stanford University (also the chair of the NBER Business Cycle Dating Committee that officially dates the beginning and end of recessions) calls this the Iron Law of Econometrics – the variance of a proper forecasting approach will always be smaller than the variance of the actual data. The reason is that if actual returns are equal to expected returns plus a random error,
R = E[R] + e
then a proper forecast is one where the errors are independent of (not correlated with) the expected returns. That means that the variance of actual returns – call it V(R) – must be equal to the variance of your expected returns V(ER) plus the variance of the error terms V(e). As long as there is any forecast error at all, an efficient forecast will always be one where your expected returns are less variable than what actually takes place. Forecasters hate this, because they like to make big, flamboyant predictions about a whole string of events, rather than focusing on the present moment.
Consider that hat full of marbles again. Suppose you are told that 80% of the marbles are green, and that 10 marbles will be drawn (with replacement). If someone asks your forecast, it’s very likely that you’ll be comfortable predicting that 8 of the marbles will probably be green.
Now suppose the first marble is drawn, and suddenly, someone switches the hat, right in front of you. What happens to your confidence in your forecast? Well, it should collapse, because suddenly you’re facing a new X. If the information set X can change, then it is not reasonable to make forecasts that assume that it will be constant over the forecast horizon.
So if we don’t want to assume that market returns are simply constant at 10% regardless of valuations or other conditions, and we also don’t want to make inefficient forecasts, what is the alternative?
For us, it is to focus on the present moment. We focus on “conditional expected returns” – the return we can expect, given the particular information set X that we have in hand. This is generally written E[R | X]. But unlike forecasters, we recognize that the predictable component of market behavior for any given period is so small, relative to random noise, that making specific forecasts is futile. We take our information set one X at a time, and we rely on discipline and the law of large numbers to mute the impact of that random noise over the long-term.
Specifically, we can go back over history and use observable conditions such as valuations, market action, overbought/oversold status, macroeconomic factors, and so on to separate history into various “bins.” Each bin represents a combination of observable conditions occurring together (what I’ve called “X”). Then we can ask, for every observation in the bin, what was the market return over a short subsequent period like a week or a month. Each bin then can be associated with a particular expected return and risk profile. Our basic practice is to align our investment position with the set of conditions that we observe at each moment, and to shift our position as the evidence shifts.
Rather than treating the next week, month, quarter or year as a horizon that demands a specific “forecast,” we simply treat each realization as part of a “repeated game,” and rely on the law of large numbers – that is, the idea that if we follow our discipline period after period after period, over time our inevitable errors will average out, and our long-term results will be largely what we expect. The best way to take good care of the future is to take good care of the present moment.
But isn’t E[R | X] a forecast?
One might object that by aligning our investment position with the average return/risk profile associated with a given set of conditions, we must, by definition, be forecasting. This is true in the sense that we do have some expectation that market returns under a given set of conditions will be satisfactory or unsatisfactory, given the risks involved. But we differ from “forecasters” in recognizing that the expected return E[R | X] for any short period of time is overwhelmed several times over by the conditional error term “u”. It is only over many, many repetitions that the error terms dampen out.
This is a property that statisticians call “consistency.” Specifically, if a process is consistent, then as you increase the number of observations some random outcome, the average value of your observations will tend toward the true “population” average.
[Geek’s Note: If R = E[R | X] + u, then over N repetitions, the standard deviation of the average error is the standard deviation of the actual error terms, divided by the square root of N. So if your conditional error terms tend to have a mean of zero, plus or minus 2.5% on a weekly basis, you would expect that over 100 weeks, your average error would be zero, with a standard deviation of about 0.25%. Over a full market cycle, you will have made a lot of individual mistakes in your investment position, but as long as your errors are not systematic, the combination of discipline and the law of large numbers will work strongly in your favor. Your results will be largely as you expected despite the fact that you made lots of individual errors along the way].
This is basically the dynamic at work when you sail a boat. If you hop into a sailboat and start across Lake Michigan, it is not particularly helpful to make predictions about the direction and speed of the wind over your entire journey. Much better to align your sails as those conditions change, making numerous modest errors, but getting across the lake.
“Suppose the mind consciousness is observing an elephant walking. During the time of observation, the object of mind consciousness may not be the elephant in and of itself. It may only be a mental construction of the elephant based on previous images of elephants that have been imprinted in store consciousness.
“Inquiry means not using the mental creation, but allowing yourself to get in touch, and to try to see how things truly are. We practice not to be influenced by the name, because when we are caught in the name we can’t see reality.”
Thich Nhat Hanh
It is important that we don’t place so much emphasis on “average outcomes” that we ignore the facts about particular instances. We still have to look carefully at reality to make sure that we aren’t assuming away particular features that are important.
This is a risk that market participants seem to be taking here in a major way. Specifically, we have seen a great number of research reports with the basic thesis of “The recession is over. Here is how the market (or the economy, or employment, etc) has performed after a recession is over.” The difficulty is that these are basically attempts to say “here is an elephant” and then immediately move to describing elephants in general, when in fact, this particular elephant is very likely to be pink, or white. Specifically, valuations here are far different than they have been at the beginning of the typical economic expansion. Moreover, economic expansions have historically always been paced by rapid expansion in debt-financed classes of expenditure such as housing, capital spending, and sustained (not just one-off cash for clunkers) demand for automobiles. In prior recoveries, debt-financed expenditures have turned up quickly and have typically led other classes of expenditure by nearly a year.
If we want to see things as they truly are, we have to look both at the elephant, and at anything that might set this particular elephant apart. With regard to the investment markets, if we suspect that the particular features of the present situation make things “different” than they have been historically, then it is best to look closely and get more data.
As an example, during the late 1990’s, it was often argued that technological innovation had changed the economy so profoundly that the market valuations of the time were actually reasonable, if not incredibly attractive (remember Dow 35,000?). So we had to open ourselves to the possibility that things were different in an important way. But when we actually looked at the data, there was simply no historical example – in any productivity spurt since the Industrial Revolution – that could support the sort of growth rates that were implicitly priced into stocks.
When we look at the current market environment today, it is clear that the enthusiasm about the market here is largely based on the idea that the recent recession is over, and that the economy will form a “V” shaped recovery similar, but much stronger quantitatively, to standard post-war recoveries. This is a very difficult argument to make, because the drivers of economic growth that existed in typical economic recoveries – particularly debt origination and consumption growth – are very compromised at present. Our perspective on the ongoing credit risk in the economy is much like that of economists Kenneth Rogoff and Carmen Reinhart, who foresaw the recent financial crisis, and are far less sanguine about the prospects for sustained recovery.
As I’ve discussed in several weekly comments, this is a subject that I have struggled with in recent months. Even if we could assume that the recent crisis was a standard post-war downturn, and that we are now in a standard post-war recovery, valuations would still concern us because at these levels, stocks are not priced to deliver satisfactory long-term returns in any event. However, we would have a greater willingness to take a moderate speculative exposure based on market action and prospects for sustained economic improvement. On the other hand, when we include other post-crash periods into our data set, and allow for the possibility that those instances better describe present conditions, the case for accepting speculative exposure is much more limited. Of specific concern is the tendency in those periods for strong advances (as we’ve seen in recent months) to be followed by spectacular failures.
So we have to be very careful about how we name things. When people label stocks as being in a “bull market,” the implicit suggestion is that stocks will continue to advance for a sustained period of time. When people say that the recession has ended and we’re now in a “recovery,” the temptation is to look at how the market has performed in previous recoveries, without noting the profound differences between those instances and the current environment.
As Thay says, “We practice not to be influenced by the name, because when we are caught in the name, we can’t see reality.” The picture in our head can be very influenced by the words we attach to it.
As Zig Ziglar says, “You can tell your wife that she looks like the first day of spring, or you can tell her that she looks like the last day of a long, hard winter. There is a difference.”
In Zen, there is a teaching tool known as a “koan” – a question that serves as the object of meditation, and is intended to reveal something about teachings like mindfulness and interconnectedness. Western observers sometimes mistake these for riddles, non-sequiturs, or nonsensical statements, but if you look at them carefully, they are questions or stories intended to prompt the listener to see things as they really are.
A riddle is something like this:
Q: “How does a Zen monk know his pizza is enlightened?”
A: “It’s one with everything.”
Here is a koan:
A novice monk approaches his teacher and asks, “Is this a bull market or a bear market?”
The teacher replies, “If it is a warm day, and I say that it is winter, will you still wear your heaviest coat?”
Causes and Conditions
“This is, because that is. This is not, because that is not.”
“The seed and the fruit are not two different things. The fruit is already contained in the seed. It’s waiting for different conditions in order to be able to manifest. The fruit doesn’t have a separate existence; it’s a formation. Using the word “formation” reminds us that there is no separate existence in it. There is only a coming together of many, many conditions. ”
Thich Nhat Hanh
When we think about events, either in our daily lives, or in the market or the economy, it is important that we don’t think of them as simply existing or coming out of nowhere. This is, because that is. This is not, because that is not. We cannot create or remove a condition, expect it to emerge or expect it to disappear, without understanding the seed that produces it, and the causes and conditions that allow it to spring up.
Generally speaking, the seed we water is the one that grows. That’s why if we spend our energy thinking about what we don’t want, what we don’t like, what is wrong – we’ll tend to nurture and strengthen exactly the wrong things. If we water the seeds of peace, understanding, empathy, happiness, and so on, those are the seeds that will grow.
The basic condition for anything to emerge is for the seed to exist. But that is not enough. The seeds of a bear market are often fully present in the later stages of a bull market – overvaluation, excessive speculation, acceptance of risk without sufficient compensation, extension of credit to poor credit risks, belief in the sustained growth of cyclical businesses, overconfidence, and so forth.
But in order to manifest as a flower, or a weed, or as fruit, other conditions have to be present. Buddhists distinguish two kinds – “same direction” and “opposing direction.”
Conditions in the opposing direction tend to hold back the manifestation of the seed, but can also force it to become stronger before it manifests. If you plant a seed in firmer soil, the roots may be forced to dig deeper in order to establish themselves and find water, whereas a seed in easier soil may grow more quickly but have weaker foundations, so it can be uprooted easily. Conditions in the same direction are those like water and sunlight, which provide the background environment necessary for the seed to grow.
Some of our best investment insights have been driven by this focus on causes and conditions. These often take the form of “Aunt Minnies” – sets of conditions that may not mean much by themselves, but have very strong implications when they occur together (a person may have one feature or another, but if you have just the right combination, you know it’s Aunt Minnie). These include, for example, the conditions I noted in A Who’s Who of Awful Times to Invest, and our recession warning composite. To find Aunt Minnies, we look for a seed, identify conditions in the opposing direction (if any) that have made the seed strong, and then look for conditions in the same direction that are capable of bringing the seed to fruition.
Many of my concerns about the markets in recent years have emerged because too often, financial market participants and policy makers focus on manifestations rather than causes and conditions. This is why investors produced the dot-com bubble, the tech bubble, the mortgage bubble, the debt-financed private equity bubble and the commodity bubble without thinking of the seeds of crisis that were latently emerging, or how violently they would manifest. Our policy makers have bailed out poorly run financials by creating massive federal deficits, and think they’ve solved the problem in the same way as someone who runs over a weed with the lawnmower. The roots have simply grown deeper, because the seeds are still there, but we’ve applied a few conditions in the opposing direction. Those of you who have read these missives for a long time know that my geopolitical views are largely the same. This is, because that is. This is not, because that is not.
We can have an overvalued market and the seeds of a bear market, but if we apply opposing conditions in the form of easy money in order to prop up the market and prevent the consequences of bad behavior, the seed will simply grow stronger, and its ultimate manifestation will be more powerful. We can have a mortgage market that is setting new records for delinquencies and foreclosures every month, combined with increasing unemployment and a heavy reset schedule on Alt-A’s and option-ARMs that is just now picking up. But we lower the bar on financial reporting, fail to restructure debt, and ignore the strengthening seed because we’re single-mindedly enthusiastic about the thin-rooted green shoots of stabilization – born solely of a burst of fiscal profligacy – then we’ll predictably be blindsided when the problems re-emerge.
Predictably blindsided. That’s happened again and again in recent years. And it happens when we fail to think about the seeds we are watering. If we look only for fruit and ignore the seeds of crisis, then every bit of fruit will be followed by crisis, and nobody will understand why.
“As thin as this sheet of paper is, it contains everything in the universe in it.”
Thich Nhat Hanh
If you look closely at a sheet of paper, you can see the clouds, the rain, the soil, the sunshine, the mill, the truck, and so forth, because without these things, there would be no sheet of paper. In Buddhist terms, the paper is “empty” and has no self. That doesn’t mean that the paper is not there, but rather that the paper is made entirely of non-paper elements. Empty of self means full of everything non-self.
There’s a phrase alambana pratiyaya – which means that object and subject are always born together. The idea of interbeing is that nothing has a separate existence – that each thing is connected to the others. It’s an inherently peaceful way of thinking, because it recognizes that we are all made of the same substance, that to take care of others is to take care of ourselves, and that we can only understand something if we understand the context that surrounds it.
So here’s a koan – “What is the sound of one hand clapping?”
If you think about it as a riddle, you’ll keep looking for the punch line. But the koan is really about encouraging the listener to consider the true nature of things. Nothing is possible in the absence of interbeing. Subject and object must occur together or nothing manifests at all.
Here’s another one – “If a tree falls in the forest and nobody is there to hear it, does it make a sound?”
Our immediate impulse is to think, of course it makes a sound. But look more carefully. If a tree falls, it certainly will make the air move, but what is sound? Sound is the interpretation that our brains give to those air vibrations. If we are not there, the air vibrates, but is the experience of sound there? One might think, but wait, we could put a microphone there in the forest. But what is the microphone picking up? The air vibrations. If we play that recording on a video monitor with no speakers, you’ll see visual images, but no sound. In order to get sound, you have to have speakers, and the speakers simply take the recorded signals and turn them back into air vibrations, which become what we call “sound” when there is a brain to interpret them. Subject and object have to occur together.
So here’s another koan – “If a share of stock is sold in a forest, and nobody is around to buy it, does it still generate a fill?”
The immediate implication of interbeing is that we are forced to think about “general equilibrium” rather than imagining that one side of a trade can exist without the other. This immediately clarifies all sorts of misconceptions that we could fall victim to if we aren’t careful.
For example, it immediately tells us that “cash on the sidelines” is not a useful concept, except as a measure of issuance. See, whatever “cash” is there on the sidelines exists because government has created paper money, or the Treasury has issued bills, or because companies have issued commercial paper. Until those securities are actually physically retired, they will and must remain “on the sidelines” because somebody will have to hold them.
If Mickey wants to sell his money market fund to buy stocks, the money market fund has to sell commercial paper to Nicky, whose cash goes to Mickey, who uses it to buy stocks from Ricky. In the end, the commercial paper Mickey used to have is now held by Nicky. The cash that Nicky used to have is now held by Ricky, and the stock that Ricky used to have is now held by Mickey. There is exactly the same amount of “cash on the sidelines” after this transaction as there was before it.
Similarly, money never moves “into” or “out of” a secondary market, or from one sector to another. If I bring $1 “into” the stock market, that same dollar goes back “out” a moment later in the hands of a seller. If it did not, there would be no trade, no fill.
We can talk about differences in eagerness or in pressure as moving stock prices. But we cannot talk about money going in or money going out. We cannot talk about supply being greater than demand or vice versa. In equilibrium, the two must be equal.
One of the most useful ways of interpreting price and volume behavior is this: if something makes a given trader want to buy, the price must move in a way that either removes that impulse or induces another trader to sell. There is no other option.
Here’s another koan:
A novice monk approaches his teacher and asks “What is the price movement of one share being bought?”
The teacher holds out a cypress leaf in his palm and asks, “Did I catch the leaf as it fell from the tree, or did I raise it from the ground?”
We are used to thinking that the act of buying necessarily implies rising prices. But think about this for a second. In either case, the teacher gets the cypress leaf. What makes the difference so far as direction is concerned is where the pressure is coming from. If the cypress leaf is being offered down by gravity, it is caught on a decline. If the leaf is being lifted by the teacher, it is caught on an advance. Remember that. It is easy to get trapped in wrong thinking by people who talk about “cash on the sidelines” or talk about “investors” buying or selling in aggregate.
There was no excess of stock that was “sold” in March that has to be “bought” back now. Investors didn’t “get out” of the market last year, and we shouldn’t think that they have to “come into” the market now. Every share that was sold was bought. That has been true for every minute of every trading day since the beginning of the financial markets.
Prices and Volume
A good way to think about prices and trading volume is to abandon the idea that money goes in or out, and to think instead about the market as a collection of various groups. Imagine there being fundamental investors, who are interested primarily in value (buying on weakness and selling on strength), and technical investors, who are interested primarily in trends (selling on weakness and buying on strength). These people also trade on different horizons and base their trading on different extent of movement.
In this sort of equilibrium, trading volume is a measure of strong views and disagreement. As the market turns weaker, trend-following investors typically abandon stocks, while fundamental investors accumulate. The reverse is true on significant strength. So spikes in trading volume tend to occur primarily at extremes relative to the target prices of fundamental investors. Volume spikes also tend to be correlated with a series of positive or negative shocks that then abate. In contrast, dull volume is a measure of low sponsorship, strong agreement, and lack of external shocks.
Equally important is that net incipient buying from both technical and fundamental investors cannot exist, so large price movements are typically required to relieve the disequilibrium. If you’ve got an overvalued market which then loses technical support, the outcome can be extremely negative, because technical investors are prompted to sell, but fundamental investors have weak sponsorship at that point, so large price declines are required to induce the fundamental investors to absorb the supply.
In contrast, if you’ve got an undervalued market where fundamental investors raise their outlook, the demand from fundamental investors is not typically provided by technical investors (who would tend instead to buy on advances in price), so the price must increase enough to induce fundamental investors with shorter horizons to supply the stock.
All of these dynamics have been active in the market over the past two years, but the most significant outlier has clearly been the past few months, where volume behavior has demonstrated much weaker sponsorship than we would have expected for an advance of this size. Normally, the volume characteristics we’ve seen have been much more typical of short-squeezes and less durable advances.
Presently, my primary concern is that stocks are now overvalued, to about the same extent as they were in the late 1960’s, and just prior to the 1987 crash, but certainly less overvalued than they were at the 2000 or 2007 peaks. Our 10-year total return projection for the S&P 500 is centered modestly above 6% annually, even if one assumes that the long-term path of earnings has been unchanged by the events of recent years. If we assume that the economy will require a much longer period to recover than has been typical of post-war recessions, the prospects for long-term returns are lower, but we don’t need to assume this in order to be concerned about valuation here. (The green, orange, yellow and red lines imply terminal price/peak earnings multiples of 20, 14, 11 and 7 a decade from now. The dark blue line charts actual annual total returns over the subsequent decade).
Though rich valuations and a fresh overbought condition last week argue for tepid returns going forward, my expectation is that strong downward pressure would be most likely if market internals deteriorate somewhat – particularly in terms of breadth. Again, if technical investors are prompted to sell in an environment where sponsorship from fundamental investors is weak, large price changes may be required to relieve the disequilibrium.
A quick summary
Present moment, only moment. Sound investment does not require forecasts. It is enough to align the investment position with the prevailing, observable evidence.
Labels can help to classify, but they can also obscure truth. There is no quantitative substitute for mindfulness. That said, if “this time is different,” one should be able to find appropriate parallels using a sufficiently broad set of historical or international data.
The seed and the fruit are not two different things – significant market moves are generally the fruit of causes and conditions that latently precede them.
Everything, including the market, is ultimately empty of a separate self. One market can only be understood and analyzed in the context of other markets and conditions. Supply and demand, in particular, should not be considered in isolation.
Finally, Thay would add something more, which is to breathe, bring yourself back to the present moment, and recognize that even the smallest, simplest thing can be the basic condition for your happiness.
“If you touch one thing with deep awareness, you touch everything.”