John Hussman, a well-known name in financial analysis, provides insightful perspectives on market dynamics and investment strategies. Often recognized for his rigorous analysis and valuation-driven approach, Hussman’s commentary is particularly valuable for investors seeking to understand the complexities of market cycles. This article delves into Hussman’s philosophy, particularly his concept of identifying “the good without the awful” to navigate the market and pinpoint bullish opportunities.
Hussman’s approach, while sometimes characterized as bearish due to his emphasis on risk management, is rooted in a deep understanding of market history and cycles. He gained recognition as a “lonely raging bull” coming out of the 1990 recession and shifted positive again in early 2003 after the 2000-2002 downturn. However, his cautious stance during more recent cycles has led to the “permabear” label. It’s crucial to understand that Hussman’s defensiveness was validated by significant market events – the 2000-2002 tech bubble burst and the 2007-2009 financial crisis. These events, as Hussman points out, were severe enough to erase years of market gains, highlighting the importance of risk awareness in investing.
Despite periods of bearishness, John Hussman emphasizes that market cycles inherently include bullish opportunities. His analysis indicates that historically, return/risk estimates have been positive approximately 65% of the time. This perspective underscores that constructive market conditions are not anomalies but rather a recurring feature of market cycles. For investors aiming to outperform the market over time, understanding when and how to become bullish is as crucial as knowing when to be defensive.
Drawdowns are an inevitable part of market cycles, and John Hussman contextualizes these within a broader historical perspective. He notes that the average bear market loss is around 32%, and even deeper during secular bear markets. The extreme valuations seen since the late 1990s contributed to substantial market plunges in 2000-2002 and 2007-2009. Hussman emphasizes the importance of considering even severe historical scenarios, like the Depression era, to build robust investment strategies. He argues against solely focusing on data from bubble periods, as this can lead to strategies ill-prepared for significant market downturns.
Addressing the “permabear” label directly, John Hussman clarifies that his approach in the 2009-early 2010 period was shaped by the necessity to consider Depression-era outcomes. He highlights the critical “two data sets problem” – incorporating both typical market cycle data and extreme historical scenarios into investment models. By spring 2012, Hussman felt his methodology had adequately addressed these extraordinary factors, moving beyond what he considered an exceptional period. Since then, his defensiveness has been of a more “ordinary, repeatable variety,” similar to his stances near the market peaks of 2000 and 2007. This nuanced view demonstrates that Hussman’s caution is not a constant stance but rather a response to specific market conditions and risk assessments.
Looking ahead, John Hussman believes that market cycles will continue, offering both periods of risk and opportunities for constructive investment positions. He advocates for focusing on what is typical in a market cycle – which, contrary to popular perception during bearish phases, is not perpetual defensiveness, but rather identifying and capitalizing on bullish phases. While current market conditions may still warrant caution, Hussman’s outlook is forward-looking, anticipating future opportunities for profitable investment.
The “Good Without The Awful” Principle
John Hussman articulates a core principle for identifying optimal times to invest: seeking “the good without the awful.” This means looking for market conditions where positive trends align with the absence of significantly negative factors. Specifically, he suggests that the best times to be bullish occur when a market decline to reasonable valuations is followed by an improvement in market internals. These internals include breadth, leadership, positive divergences, and price-volume behavior, indicating underlying market strength.
In essence, “the good without the awful” framework emphasizes a balanced approach. It’s not just about identifying positive signals but also ensuring the absence of red flags like overvaluation, overbought conditions, and excessive bullish sentiment. This principle aims to filter out periods where potential gains are offset by substantial risks.
To illustrate this principle, John Hussman presents a simplified model using easily understandable indicators. It’s crucial to note that Hussman emphasizes this is for illustrative purposes and not a model he uses directly in practice. This model serves to demonstrate how combining “good” and “awful” criteria can differentiate market environments.
“The Good” Criteria (Positive Signals):
- S&P 500 Dividend Yield Trend: S&P 500 dividend yield below its level from 6 months prior. This acts as a trend-following measure, suggesting positive market momentum.
- Dow Utility Average Strength: Dow Utility average above its level from 6 months prior. This indicator captures trend-following, divergence, and interest-sensitive aspects of the market.
- Treasury Yield Trend: 10-year Treasury yield below its level from 6 months prior. This reflects a favorable interest rate environment.
Points are assigned for each criterion met, with 2-3 points categorized as “The Good” and 0-1 points as “Not Good.”
“The Awful” Criteria (Negative Signals – all three must be present):
- Shiller P/E Ratio: Shiller P/E (CAPE Ratio) above 18, indicating overvaluation relative to historical earnings.
- Investor Sentiment: Investment advisors’ (Investors Intelligence) bullish sentiment greater than 45%, signaling potential overbullishness and contrarian risk.
- Market Advance from Lows: S&P 500 more than 50% above its 4-year low, suggesting a potentially extended and vulnerable market.
A chart illustrating the historical cumulative performance of “The Good without The Awful” investment strategy compared to the S&P 500 index total return since 1960, demonstrating periods of outperformance and drawdown management.
The model’s historical analysis since 1960 reveals that periods characterized by “The Good without The Awful” – occurring 41% of the time – delivered an impressive average annual total return of 21.4%, significantly outperforming Treasury bills. Conversely, when “The Good” was coupled with “The Awful” (10% of history), the market experienced losses. This simple model effectively partitions market history into periods with drastically different return profiles. It underscores John Hussman’s point that optimal investment strategy involves selectively embracing market risk only when expected returns justify it.
The chart presented in the original article visually reinforces the effectiveness of “The Good without The Awful” approach. It shows the cumulative performance relative to the S&P 500, highlighting periods of significant outperformance and notably smaller drawdowns compared to the index. Even after accounting for transaction costs, this simplistic model demonstrates the potential of strategically timing market exposure based on combined positive and negative indicators.
While John Hussman acknowledges the model’s simplicity and illustrative nature, its historical performance emphasizes the core principle: combining positive market trends with the absence of critical negative factors can significantly improve investment outcomes and manage risk effectively.
Conditional Returns and Investment Discipline
John Hussman further elaborates on the concept of “conditional returns,” emphasizing that market returns are not uniform but vary significantly based on prevailing market conditions. Effective investment criteria should help investors “partition” market data into subsets with distinct return/risk profiles. “The Good without The Awful” model serves precisely this purpose, separating periods with high conditional returns from those with low or negative returns.
For instance, the model effectively divides the S&P 500’s historical annual total return since 1960 into two subsets: one associated with a high average conditional return (21.4% when “The Good without The Awful” criteria are met) and another with a much lower average conditional return (just 2% otherwise). This stark difference highlights the value of identifying and acting upon market conditions that favor positive returns.
John Hussman also references his broader “ensemble methods,” which he utilizes for more comprehensive return/risk assessments. These sophisticated models, while not detailed in this article, further refine the concept of conditional returns, partitioning market history into even more granular segments with varying expected outcomes. For example, periods identified as the most negative 5% historically by Hussman’s ensemble methods have been associated with substantial average annual losses. This insight justifies a defensive investment posture during such periods, even if it feels “uncomfortable” in the short term.
He notes that his ensemble methods have identified approximately 65% of historical periods since 1940 with positive return/risk estimates, associated with a high average annual S&P 500 return. Conversely, about 30% of periods suggest a fully hedged stance, with near-zero average returns. This distribution underscores that constructive market conditions, while not constant, are historically more prevalent than extreme negative scenarios.
John Hussman stresses the importance of investment discipline in adhering to a well-defined strategy, even when short-term market performance might seem to contradict it. He points out that even “The Good without The Awful” model, despite its historical outperformance and drawdown management, had periods of underperformance. Specifically, it hadn’t gained net ground since October 2011 in the context of the original article’s writing (January 2013). In contrast, an unhedged S&P 500 position had performed better during that specific period.
However, Hussman argues against abandoning a sound long-term strategy based on short-term fluctuations, especially at what appears to be a point of heightened market risk. This highlights the critical distinction between long-term investment strategy and chasing short-term performance. Discipline, a robust investment process, thorough research, historical evidence, and a focus on full-cycle characteristics are paramount for long-term investment success.
In conclusion, John Hussman’s analysis provides a valuable framework for understanding market cycles and making informed investment decisions. His emphasis on “the good without the awful,” conditional returns, and disciplined adherence to a well-researched strategy offers a compelling approach for navigating market complexities and achieving long-term investment goals. While market conditions are constantly evolving, Hussman’s principles provide a timeless foundation for thoughtful and risk-aware investing.
