Reply #52: Time Inconsistency

[54anickel]

You'll have to ignore the fact that he's pushing a particular fund. His statements about the market in general are worth reading about though. Sorry if parts of it read like an advertisment.

http://www.hussmanfunds.com/wmc/wmc040913.htm

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In general, buy-and-hold isn't a bad strategy, and is surely better than the strategy of constantly leaping from hot fund to hot fund on the basis of short-term performance. At present, however, buy-and-hold strikes me as a decidedly suboptimal solution to the time inconsistency problem. I emphatically believe that the S&P 500 is priced to deliver very disappointing long-term returns from current levels, for as long as 5-14 years. That view doesn't rely on unusual assumptions about future valuations or earnings growth rates, and doesn't even require the assumption that stocks will ever become significantly undervalued on historical benchmarks.

In any event, it's clear that constant short-term optimization and comfort-seeking is a very different objective than long-term optimization. Probably the closest you can get to pure short-term comfort-seeking in the financial markets is active trend-following – buy the rallies, sell the declines, buy the rallies again. It isn't any coincidence that especially in this year's market, investment systems that follow that sort of approach (e.g. managed futures) have been decimated by whipsaws in which rallies failed just after being bought, and declines reversed just after being sold.

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As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and tenuously favorable market action. Earnings for the S&P 500 have increased substantially over the past year, taking the reported figure on the index to just over $56, and resulting in a price/peak earnings multiple of about 20. That's the same level as the market reached at the 1929, 1972 and 1987 peaks, but we certainly saw a much higher peak in 2000 (near 34) before the subsequent plunge. Suffice it to say that valuations aren't cheap, and that even the considerations of interest rates and inflation are not sufficient to change that conclusion. Earnings for the S&P 500 remain well ensconced in their long-term peak-to-peak growth channel of 6% annually. On the basis of the price/peak earnings multiple, the historical average is about 14, and the historical median is 11.

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In bonds, the Market Climate continues to be characterized by modestly unfavorable valuations and market action. Despite the recent softening of oil prices and an accompanying pullback in the PPI, the potential for further economic weakness is largely offset by the potential for further core inflation pressures and U.S. dollar weakness. At present, our duration remains fairly modest at just 2.3 years, mostly in TIPS, with about 14% of assets in the Strategic Total Return Fund allocated to precious metals shares.