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Tuesday, December 14, 2010 11:05 AM

An Awful Time to Invest; Reflections on "Lost Opportunities"

Mish Moved to MishTalk.Com Click to Visit.

John Hussman has another excellent column this week that is a must read for investors. Short-term traders, especially day traders, need not bother. Everyone else could use a refresher course in risk management.

Please consider Warning - An Updated Who's Who of Awful Times to Invest

In recent weeks, the U.S. stock market has been characterized by an overvalued, overbought, overbullish, rising-yields syndrome that has historically been hostile to stocks. Last week, the situation became much more pointed. Past instances have been associated with such uniformly negative outcomes that the current situation has to be accompanied by the word "warning."

The following set of conditions is one way to capture the basic "overvalued, overbought, overbullish, rising-yields" syndrome:

1) S&P 500 more than 8% above its 52 week (exponential) average
2) S&P 500 more than 50% above its 4-year low
3) Shiller P/E greater than 18
4) 10-year Treasury yield higher than 6 months earlier
5) Advisory bullishness > 47%, with bearishness < 27%
Hussman lists nine occasions that met those criteria. The best of them suffered a quick 7% loss. Over half of them had losses of 17% or greater in a 3 month or longer time horizon. One third of them had losses 34% or greater in as short as 3 months.

Yet, the market climbs. And it may continue to climb. And if it does, it will not mean that prudence was unwarranted.

Some people will not roll the dice when the odds are against them. Others understand nothing but momentum. Still others, the vast majority, don't really understand anything at all. Instead, they follow whatever the cheerleaders on TV say.

Hussman continues...
From our standpoint, the return/risk profile of the equity market is the most negative that we ever observe historically, so we are willing to speculate neither on the hope for government wisdom, nor on the hope for government recklessness. Investors who are convinced that monetary and fiscal actions will drive the market ever higher can easily offset our hedges by establishing exposure to the S&P 500 or more speculative alternatives. What I can't do on behalf of those investors is violate our discipline and take a speculative exposure in an environment where the historical evidence indicates an extraordinarily hostile return-to-risk tradeoff.

Still, it would be an understatement to say this has been an unusual cycle. Given the broader set of Market Climates we have defined, I am confident that we will periodically observe more favorable market environments - possibly even in the coming months, without major changes in market valuation - where we will be able to accept risk in the expectation of positive returns. From my perspective, this is emphatically not one of them.

The last thing we want is to be inadequately hedged in an indiscriminate selloff because we believed our stocks did not have much "beta."
Catching Every Rally Is Easy

Catching every rally is actually easy. All you have to do is buy a basket of index funds and hold them. Of course doing so will occasionally result in losses of 40% or greater as happened in 2008.

Had you bought the S&P 500 10 years ago and held on for dear life, you would have caught every rally and over those 10 years you would be about even. Had you done that in the Nasdaq, you would be down 40% still.

Of course, had you put everything on gold, silver, and energy and walked away you would have been a huge winner. However, that is not the way general funds invest or should invest. Secondly, that may have been a quite reasonable thing to do a few years back, it is much tougher to make the same case now.

Diversification No Savior

Diversification did not help in 2008. Given similar market correlations, it is highly unlikely that diversification in a basket of US and foreign stocks will do much better on the next move lower.

Rallies Very Enticing

Rallies are very enticing. Everyone loves to party. The last big parties were the stock market in 2007, housing 2001-2005, the Nasdaq in 2000, and now. In every previous instance, the prudent thing to do was to sidestep the party and stay sober in thinking.

There will be better times to invest, perhaps even at higher levels. In the meantime, market internals remind me of 2007, and taunts once again are coming out of the woodwork.

Things are so preposterous that "investors" chased 3-year Walmart bonds yielding .7% simply because they yielded more than the same-duration treasuries. That was a mere 6 weeks ago or so. A quick check now shows 3-year treasuries yield over 1%.

Does that represent value even yet? Compared to the stock market it does. I believe there is a strong likelihood stocks will be lower 3 years from now than they are today. Admittedly that's a guess, but one based on hard evidence and rational thinking, not wishes.

Here are two things that I do know.

1. Historically speaking, this is an extremely poor time to be an unhedged investor
2. It's far easier to make up for lost opportunities than to make up for catastrophic losses

I keep wondering, was 2008 that long ago? I guess it must be because people seem to have forgotten the message.

Mike "Mish" Shedlock
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