More Respectful Disagreement with Hussman

This time from Jeff Miller, via Advisor Perspectives:

My Own Concerns about the Conclusions

Many have asked me why I have not followed this approach in my own investment management. I do not write about it very much because of the work required. Dr. Hussman has a great research budget and team. I have a small staff who are already fully-employed on stock picking and managing our programs. Going back to replicate one of the old charts would be a fair amount of work. I will share my concerns here, but only in abbreviated form.

  • We never seem to reach the point of evaluation. How did these approaches work in the past?
  • The methodology seems to include many of the classic overfitting problems. I am certainly not the first to note this. Philosophical Economics in late 2013 wrote Valuation and Stock Market Returns: Adventures in Curve Fitting.
  • There are adjustments that are not well explained. The earnings are adjusted for expected changes in profit margins, for example. What if this assumption is not accurate? Profit margins are an intense (and separate) debate.
  • The method for adjustment keeps changing – different approaches, coefficients, etc.
  • Over the years, the time frame for the forecast keeps moving, from seven, to ten, and to 12. If you go back to the original Shiller papers, he was using five years. His disciples keep experimenting with different choices.
  • The independent variables change with each new iteration. The overall model always seems to fit. Past discrepancies disappear.
  • The attribution of “bad patches” in results to market overvaluation or undervaluation. This seems backwards. Why is the market wrong and the model right?

I am especially bothered by what I see as exaggeration and distortion. What does it add to this discussion to call valuations “obscene?” I find especially distasteful the statement, “The CAPE Ratio id doing exactly what it has always done, which is to help investors anticipate the investment returns they should expect over the next decade. Those returns will very likely be in the low, single digits”.

The CAPE ratio is not some wise old friend that has been around for centuries. It was invented only recently and has not worked very well. The claim of historical validation is also completely wrong. What if I told you that the Packers always won at home after a double-digit away loss in a dome? (I made this one up, but you get the idea). It is historically accurate, but does not have any value for predicting the future. Since Dr. Shiller and Dr. Hussman made a lot of specific choices about measuring earnings, past time frames, use of inflation information, and future time frames, their conclusions should be described as a model, not some definitive historical record. It is rather easy to create a view of history that provides a vastly different conclusion. (see The Single Greatest Predictor of Future Stock Market Returns). It includes this impressive chart.

avginv11

 

[Jeff] Similar approach, vastly different result. This is not the only such example.

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