Monday, November 17, 2008

Hedging Is Simple, But Market Timing Is Not

What follows is some perspective on the buzz we're hearing about portfolio and fund manager performance in this horrendously painful bear-market year, which most investors would love to forget about--if only they could.

While Miller Missteps (Again) . . .

Recall that around this time in 2005, Bill Miller was being hailed as the most successful fund manager of all time, with his Legg Mason Value Trust Fund outperforming the S&P 500 for a record-breaking 15th straight year. Then, in 2006, Value Trust underperformed for the first time since 1990, returning just 6% versus the S&P 500's double-digit 16%. Last year, in 2007, Miller again underperformed, this time -7% (i.e., a loss) for Value Trust versus a 5% gain for the S&P 500. In 2008, as of last Friday, Nov. 14, Value Trust is down a whopping 50%, versus a 40% decline for the S&P 500, making it quite likely that Miller will underperform once again--for the third straight year.

In his third-quarter commentary published last week (Nov. 12), Miller discusses flaws in the government's delayed ("too late") response to the financial crisis, while also admitting,
"I have made enough mistakes in this market of my own, chief among them was recognizing how disastrous [government] policies being followed were, yet not taking maximum defensive measures [italics mine], believing that the policies would be reversed or at least followed by sensible ones before things got completely out of control."
Miller is alluding here to his failure to implement an appropriate hedging strategy to protect his fund against the precipitous collapse of the market during the past couple of months. With 20/20 hindsight, of course, it is easy to say that he (or anyone long the market) should have either sold their equity holdings, shorted S&P 500 futures, or bought puts to protect the downside.

. . . Hussman Hedges

While most equity fund managers, like Miller, are suffering complete and unforgiving drubbings this year, one fund manager is making news due to his notable outperformance in this year's most disastrous market in decades. John Hussman's Strategic Growth Fund (HSGFX) is running only slightly negative year-to-date through Oct. 31, which sure beats the 40% or larger decline most fund managers are experiencing. Of course, Hussman's stand-alone performance begs the question, what's his secret formula?

Though academic credentials do not necessarily or even typically help one become a better investor, perhaps at least it is no detriment to his performance that Hussman holds a Stanford economics Ph.D. and is a former finance professor at the University of Michigan. His investment strategy, as described on his website and in his fund's prospectus, seems to be a rational approach firmly grounded in interpreting historical data, utilizing "observable evidence" (sounds scientific . . .) in an attempt to distinguish between favorable and unfavorable "market climates" (weather forecasting analogy?), taking into account both "market action" (an allusion to physics or sports?) and valuation (yeah, he has a value-investing approach, similar in some respects to Buffett and Grantham).

To date, Hussman's differentiator has been his hedging. What really distinguishes his investment style from that other fund managers is his ongoing implementation of partial or full hedging of his underlying long-equity portfolio, even though he could potentially become fully invested or even leverage up beyond full exposure if market conditions ever call for it:
"In conditions which the investment manager identifies as involving high risk and low expected return, the Fund's portfolio will be hedged by using stock index futures, options on stock indices or options on individual securities. . . . The Fund will typically be fully invested or leveraged when the investment manager identifies conditions in which stocks have historically been rewarding investments."
In Hussman's framework, although market action remains unfavorable, the market's recent decline has shifted valuation from unfavorable to more favorable, leading him to begin transitioning his portfolio from being fully hedged (underlying stock positions essentially 100% protected by put-call combinations as of a few months ago) to taking on moderate market exposure (now 70% to 80% protected). Currently, Hussman views any near-term market declines as opportunities to strip away a few more layers of protection and increase market exposure, since stocks have become "both undervalued and oversold."

Because Hussman varies the amount of his protection (or exposure) to market moves in accordance with market conditions, he is, in my opinion, attempting at least partially to "time" the market, even though he insists that he is not pursuing "market timing" in the usual sense of the term. In his own words from a recent weekly commentary:
"The Strategic Growth Fund is not a 'market timing' fund. Nor is it a 'bear' fund or a 'market neutral' fund. Strategic Growth is a risk-managed growth fund that is intended to accept exposure to U.S. stocks over the full market cycle, but with smaller periodic losses than a passive buy-and-hold approach. We gradually scale our investment exposure in proportion to the average return/risk profile that stocks have provided under similar conditions (primarily defined by valuation and market action). We make no attempt to track short-term market fluctuations. We leave 'buy signals' and attempts to forecast short-term market direction to other investors, preferring to align our investment positions with the prevailing evidence about the Market Climate."
Hedging Versus Market Timing

To understand the impact of hedging on Hussman's longer-term performance, we can look at his fund's returns, which he conveniently discloses both before and after hedging.

Since its inception in 2000, Hussman's Strategic Growth Fund has carved out a winning track record, as evidenced by the stellar performance chart displayed prominently on Hussman's website. For the eight-year period, while the S&P 500 has lost 1.04% annually, Hussman's unhedged portfolio has gained 6.37% annually, and his Strategic Growth Fund has returned 10.76% annually. These results indicate that Hussman's stock-picking ability (or is it luck?--more on this topic below) has boosted his annual return to some 741 b.p. above the S&P 500, while his hedging has apparently added another 439 b.p. to his annual performance. This is a very solid track record over the past eight years, particularly in light of the two bear markets fund managers have had to endure, both in 2000-2002 and beginning from the last quarter of 2007.

Before jumping to conclusions about Hussman's apparent analytical genius or market clairvoyance in largely avoiding both bear markets, let's take a closer look at the data--his data--posted here on his website for the casual (or better, not so casual) perusal by anyone interested. Taking the 33 quarters of data from the third quarter of 2000 through the third quarter of 2008, we can make a scatter plot of his unhedged and realized fund performance versus the S&P 500, as shown in the chart below.

If Hussman's realized fund performance points (in pink) on the chart seem to sketch out a typical, albeit somewhat noisy, hockey-stick-shaped option payoff diagram, this graphical result should come as no surprise, since, after all, the basic purpose of Hussman's hedging is to protect his portfolio against market declines, while allowing participation in market upside potential.

Let's take our analysis of Hussman's performance a step further. In the chart above, observe that the pink points sit above the blue points on the left half, while the reverse is true--pink below blue--on the right half. To understand this behavior, we need to distinguish between hedging and market timing:
  • Hedging: The underlying unhedged position is Hussman's long-equity exposure to his chosen portfolio of stocks. If he were always (i.e., without attempting to time the market) simply to buy put options with at-the-money or slightly out-of-the-money strikes to protect his portfolio against market downside, the puts would show a profit when the market declines but would expire worthless when the market rises. The result would be an insurance-like payoff pattern from the hedge--protection against loss in a declining market, but with a cost relative to the unhedged position particularly evident when the market rises.
  • Market Timing: On the other hand, if Hussman were attempting to time the market and successful in doing so, presumably by selectively hedging to protect against downside under risky market conditions but operating without a hedge when prevailing conditions are less risky, the data ought to show not only realized fund performance above the unhedged case (pink above blue in the chart) when the market declines, but also at least an occasional occurrence of this type of outperformance of his fund over the unhedged case when the market rises.
By inspection of the data, we can see that for the 14 quarters when the S&P 500 fell about 2% or more, Hussman's realized fund performance always exceeded the S&P 500, indicating that, to date, he has always succeeded in avoiding any sizable market loss. However, there is also a flipside to this flawless track record in falling markets, namely, in the 13 quarters when the S&P 500 rose about 2% or more, Hussman has never outperformed the market. In fact, the negative correlation between the S&P 500 and Hussmans's hedge (being just the difference between his realized fund return and his unhedged return) is a strikingly large -0.96.

What this all indicates is that Hussman's performance is basically consistent with that of someone who makes a practice of always hedging with put options, regardless of market conditions. By and large, it is not what we should expect to see from a portfolio manager implementing a market timing strategy, even though Hussman does at least occasionally remove some portion of his hedge to reduce cost when he believes that risk is low and the chance of a market rise is high.

Skill Versus Luck

The above classification of Hussman as a hedger and not a market timer is in agreement with the often-stated warning to investors and traders that market timing is difficult, if not impossible, and should be attempted only with extreme caution by anyone with risk aversion. In a Tech Ticker interview last week on the topic of skill versus luck in stock-picking and market timing, Professor Kenneth French (whose name figures prominently alongside Fama's in finance theory) states:
"There this a whole academic literature trying to figure out who won because of luck and who won because they truly had skill. We don't know how to do it. I mean there's a little bit of evidence that we can distinguish luck from skill, but, in essence, it's absolutely futile.

"So, when I have a mediocre M.B.A. student who spent the weekend studying Morningstar and is convinced he knows how to pick the winning fund, what I challenge him with is sort of, 'Geez, you know, it's good that you didn't even need to bother to get a Ph.D. and spend the last 30 years of your life solving this problem. You know, those of us who did that, we don't know how to do it. But, congratulations. That was a really productive weekend!'

". . . To basically try to distinguish skill from luck . . . [is] almost impossible. . . . What I'm saying is, I can't tell . . . one from the other. . . . If I can't tell good from bad, why play the game?"
Surely, coming from an accomplished expert in finance, this type of statement is enough to throw into question anyone's claim of having ability to pick stocks and time the market to achieve excess returns in a consistent fashion.

What this means is that we, the investing public, should not read too much into the performance of successful fund managers, however superb their performance may have been (in Miller's case) or appear to be (in Hussman's case). Both Hussman and Miller have certainly assembled relatively long track records as ostensibly excellent stock-pickers, but, as history has shown, anything is possible. If Miller's 15-year winning streak can suddenly undergo a complete metamorphosis into a 3-year (or longer?) losing streak, and if Hussman's track record is solid but exhibits inherent underperformance in rising markets as consistently as it displays outperformance in falling markets, we can only suspect that unquestionable evidence of skill, as opposed to luck, in investing has become that much harder to find.

Although anyone actively managing a stock portfolio may hate to admit it, Professor French is most likely right--unfortunately, in the world of investing, we will probably never really be able to tell if our own or anyone else's performance stems primarily from luck or, as many may want to believe, from having a discernible edge over other investors who are only almost-as-skilled as ourselves.

Friday, November 14, 2008

The Next Boom Will Come

The global economy is in the doldrums. Collapsing housing prices and ensuing foreclosures have brought both borrowers and lenders to their knees, frozen credit markets, depressed stock prices, softened consumer demand, forced oil, metal (even gold) and other commodity prices lower, and now dragged down the commercial real estate market as well. The Bush and Paulson $700 billion financial rescue plan has morphed from an impracticable illiquid-asset buyback plan to shore up bank balance sheets into an across-the-board equity infusion scheme and sadly, along its porky way, lost focus, impact and credibility. Cynics question what benefit Bernanke's many years of academic study of the Great Depression have brought him, or anyone else, for that matter. Respected business figures (for example, Soros and Dimon) warn of a deepening recession in 2009, possibly even a depression.

Given the dour outlook of economic experts and pervasive pessimism of the investing public, it's hard to be optimistic--but I am. I'm confident that better times and a stronger economy lie ahead of us. Really, a brighter future is all but inevitable. Yes, I repeat, just as day follows night, we will see better times. Let me explain the root of my optimism.

Generally speaking, two basic schools of economic thought have been most influential over the past 75 years--Keynesians (including neo-Keynesians), who advocate fiscal measures such as an increase in government spending to stimulate a sluggish economy, and higher taxes to cool an overheated inflationary economy; and monetarists (led by Friedman's Chicago school), who believe that what's more important is controlling the money supply, primarily through buying and selling government bonds in the open market and raising and lowering the discount rate. Both schools of economic thought unabashedly lay claim to real-world successes of their models--Keynesians take credit for lifting the economy back onto its feet through FDR's New Deal spending following the Great Depression in the 1930s, and monetarists boast of steady and prolonged economic growth in the 1980s (Reagan years) and 1990s--despite the many recessions we have seen, including those in recent decades: 1980 (7 months), 1981-1982 (17 months), 1991-1992 (8 months), 2001-2002 (12 months), and presumably 2008-2009.

While these two mainstream schools of economic thought certainly have their differences, they also share an important commonality--both rely heavily on government intervention to control or at least influence economic growth. President Bush's consumer-targeted economic stimulus package during the early days of the current financial crisis and the new stimulus package that President-elect Obama stressed as a high-priority item in his first press conference a week ago are examples of Keynesian policy in action. The Fed's continual "busy-body" adjustment of the discount rate--Greenspan's lowering of the rate to 1% in 2003 during the last recession precipitated by the dot-com bubble, and raising it back up to the 5% range by the time of his retirement in 2006, and Bernanke's pushing the discount rate all the way back down again to 1% last month, while hinting at more rate cuts to follow--are examples of attempts to steer the economy using monetary policy.

In sharp contrast to these two mainstream schools are those who argue that both the Keynesians and monetarists are wrong-headed. For example, the Austrian school, based on the thinking of Mises and Hayek, explain how government intervention is not the solution. Stating that fiscal and monetary policy fail to produce their intended impact, these economists insist that, instead of smoothing the vagaries of the business cycle, government intervention actually causes the booms and busts, through over-extension and over-contraction of credit at artificial prices via the highly government-regulated fractional-reserve banking system. Quite contrary to active intervention, the Austrian school recommends following a laissez-faire "do nothing" approach, theorizing that this is the only way to cure permanently our economic woes. For a coherent exposition of the Austrian school's position, see Murray Rothbard's 1969 essay, "Economic Depressions: Their Cause and Cure," here.

Which economic school is right? Well, first off, practically speaking, it would be grossly out of character and, in fact, outright political suicide for any president--whether lame-duck Bush, or our country's new icon of hope, "renegade" Obama--to tell us American citizens that, after serious dialog and lengthy reflection, the elected officials and their appointed experts have decided that a "do nothing" policy is best. With home foreclosures at historical highs and rising, and growing worries over burdensome credit card balances, auto loans and other consumer debt, the popular approval ratings of even the most charismatic of political leaders would undoubtedly suffer greatly if all their economic advisory team could come up with is to a "do nothing" strategy for tackling the current economic crisis. No, simply put, Americans are by nature more active doers than thinkers, and doing nothing never has been and probably never will be an acceptable alternative for managing our economy.

So, much to the chagrin of Austrian school economists, we must conclude that government intervention, whether effective or not, will continue when Obama and later presidents take office. Given this inevitability that politicians and their mainstream economic advisers will always be inclined to fiddle with the economy, here's the logic of what to expect:
  • If the sketchy long-run track record (performing like a "B" student, with 13 out of the 115 quarters beginning in 1980 showing negative real GDP growth, according to BEA data) of the Keynesians and monetarists is any indication, we should see at least some degree of over-shooting in the future, perhaps this time manifested by a delayed but sudden response of our economy to excessive fiscal stimulus or overly loose monetary policy, resulting in either consumer price inflation or yet another asset bubble. (On the other hand, if by chance (or fluke?) policymakers have learned from the last boom-bust cycle and this time around manage to get the economic fine-tuning exactly right, they will have realized the heroic feat of taming the recalcitrant business cycle, macroeconomic volatility will cease, and we will all live, at least economically, happily ever after. . . . but I would tend to believe other fairy tales before placing undue faith in this one, wouldn't you?)
  • If the Austrian school is correct in their critical analysis of the shortcomings of Keynesian and monetary policy, the current credit-driven bust will inevitably be followed by a boom, and the more our government intervenes to try to fix the problem, the higher the crest and deeper the trough we will see during the next boom-bust cycle.
In other words, however we dissect our economic situation, the business cycle remains alive and well. Both empirically and theoretically, we can be sure that economic booms and busts will continue. Admittedly, the precise timing is anyone's guess but, following the current, painful de-leveraging and retrenchment of credit in our financial system, at some point in the future, credit creation will again be in vogue, creating over-expansion of credit in some asset class, and soon enough spilling over into other asset classes. Yes, however unlikely it may now appear to be (case in point: was anyone predicting a collapse in oil prices to today's $58 per barrel when it soared above $140 as recently as July?), one day we will experience yet another bubble. Seeing how the collective memory of market participants tends to be selective and short, I wouldn't be surprised if such a rebound happens earlier and quicker than any respected market commentator would now dare to predict.

Suffice it to say, for anyone distraught by the current bust, please have patience: the next boom will come--maybe even sooner than you or anyone now thinks.