Financial history won’t get you through tomorrow

Recently an article on the FT website linked to Hussman Funds, which has a regular column I’ve started reading. It’s an interesting view with some good reasoning behind it, but a quote from the latest column caught my attention:

“Our present defensiveness is not driven by concerns about fresh credit or economic difficulties, but rather by a combination of overvalued, overbought, overbullish, rising-yield conditions that has generally turned out badly in post-war data. While we will remain mindful of underlying economic risks, I do believe that there is a wide enough range of outcomes in post-war data to allow us to manage the residual economic risks we face.”

This type of statement is tempting for any investor; when you can say that a certain condition had a predictable result 19 out of 20 times it seems safe and reliable. The only problem is that the past does not determine what will happen in the future. As others have been discussing recently (see item #9), the fact that past decades of low returns have been followed by decades of good returns does not mean that the US stock market will perform well until 2020. The actual reason was that the previous examples ended in very undervalued markets.

The results we get in the future will be driven by the behaviours of other investors, which are always changing as they react to the recent past. It’s true that stock markets are not at a highly undervalued point right now, which means that they aren’t likely to be driven up by rational long-term investors buying stocks at a good value. But it’s also true that they are a lot less popular than in recent years, and a resurgence in popularity could increase valuations.

This reveals more uncertainty than clarity because other investors are typically unpredictable. In the long-run one of the strongest measures of future potential is valuation but until we reach the long run anything could happen. Even in a slightly overvalued market the short-term results are not guaranteed to wipe you out.