In 1943, Milton Bradley introduced a board game called Chutes and Ladders, inspired by an 18th century game from India. The object is to make your way step-by-step from the bottom of the game board to the top, while you periodically come upon ladders that help you advance more quickly, or fall into chutes that set you back, sometimes a great distance. In the Indian game, ladders represent the good karma from following the path of virtue (faith, reliability, generosity, knowledge), while the numerous chutes represent the bad karma that follows from taking the path of vice (disobedience, debt, vanity, greed). In the Milton Bradley (now Hasbro) version, there are illustrations of children doing good or helpful actions at the bottom of each ladder, and illustrations of the happy consequences at the top. In contrast, the top of each chute depicts children doing irresponsible things, with an illustration of the unfortunate consequences at the bottom.
On October 9, 2007, the S&P 500 reached a bull market peak, which was followed over the next 18 months by a stunning market plunge which wiped out more than half of the market capitalization of U.S. stocks. As any number of weekly comments at the time should demonstrate, the crisis was the fairly predictable result, albeit of uncertain timing, of reckless speculation in the housing market, irresponsible yield-seeking among lenders, exuberant overvaluation in the equity market, overbullish sentiment, failure of investors to consider the cyclicality of profit margins, and a variety of other factors. Investors plunged down a terribly deep chute. While we avoided a great deal of damage, even our fairly cautious response to improved valuations and periodic improvements in market action in late-2008 was punished, but we slipped down a comparatively smaller chute.
Since early 2009, assisted by the largest fiscal and monetary intervention in U.S. history, coupled with changes in U.S. accounting rules, investors have essentially climbed back to rejoin us. The S&P 500 is now about even with the Strategic Growth Fund (within a fraction of 1%) since the 2007 peak. It is not clear that the policies contributing to this recovery have been particularly virtuous, driving the U.S. debt/GDP ratio toward 100%, leaving the Federal Reserve leveraged over 54-to-1, and bringing the valuation of the S&P 500 to the point where we estimate prospective total returns of just 3.8% annually for the index over the coming decade. Given the assumptions required to justify further risk-seeking and elevated valuations (permanently wide profit margins, sustained monetary distortions, further sovereign bailouts, avoidance of state and municipal strains, and other factors), there's a good chance that investors have simply clawed their way to the top of another chute, but that remains to be seen.
Nevertheless, the average investor plunged down a steep chute in the first part of the present market cycle, and has rejoined us after the recent advance. Meanwhile, we initially slipped down a more modest chute, and have more or less stayed put since 2009.
But why? Was staying put during this advance a standard feature of our investment approach? Has this period been representative of the hedging strategy in Strategic Growth Fund? Should investors expect us to respond to future advances the same way? For long-term shareholders, and frequent readers of these weekly comments, our ongoing and hopefully transparent discussion of our concerns and research efforts since 2009 should make it clear that the answer is "no."
Recall that we entered this crisis with a hedging approach that was essentially suited to the Chutes and Ladders of post-war data. While we anticipated that a significant amount of debt would have to be restructured, I expected what I called a "writeoff recession" that would not necessitate major economic disruptions, provided that bondholders accepted losses from bad loans that they knowingly made at a spread. As the crisis unfolded, policy makers chose a course far different than we viewed as appropriate (defending private debt and distressed sovereign debt with public funds, altering accounting rules to effectively allow insolvency, and aggressively damaging public confidence with catastrophic "either-or" rhetoric in order to frame the bailouts as the only option).
As the crisis unfolded, were forced to contemplate data and outcomes from prior credit crises, including the Great Depression. Those game boards were strikingly different. Conditions that would reasonably be associated with ladders in post-war data were instead associated with deep chutes in Depression-era data. Taking average outcomes of any small number of models (post-war, post credit-crisis) still led to negative expected returns, because the outcomes in Depression-era data were so hostile. So we remained defensive, choosing first to do no harm. At the same time, we responded by modifying our hedging approach, in order to broaden our ability to deal with these uncertainties in a more nuanced way. I expect that this will be of benefit in the coming years, because I do not believe that underlying credit issues facing the economy have receded to nearly the extent that investors imagine.
A side note - we make an important distinction between "risk" and "uncertainty." As I've noted before, risk describes the "spread" of a known probability distribution - for example, the chance that you'll roll something other than a 7 given that you know you're throwing two six-sided dice. Uncertainty emerges when you don't even know whether the dice have six sides, so you are forced to entertain the possibility that your entire model of the world is incorrect. In the past two years, our research efforts have been singularly directed at measuring uncertainty and dealing with it in a very disciplined way.
The simple fact is that we are all playing a game of Chutes and Ladders where it is not at all clear which game-board is applicable. To believe strongly in a certain investment outcome is to imagine that there is only one correct model of the world, and that the correct model is in hand. Investors appear very eager to apply post-war norms to the economy, and to apply the elevated valuation norms of the past two decades to the stock market. I doubt that these models represent the correct view of the world, but our approach is to allow for these possibilities and dozens of alternate ones.
As I've noted in several recent weekly comments, our eventual resolution of the "two-data sets problem," as I described it in 2009, is to discard the belief that one model, or any small number of models, is the correct way to view the world, and to instead proliferate dozens of models each estimated over different subsets of historical data and different subsets of indicators. These still emphasize measures of valuation, market action, credit spreads, interest rates, sentiment and other factors with strong theoretical and historical support, but there is no single "master" among them. The performance of the ensemble is typically much stronger (and generalizes better to new "out-of-sample" data) than any of the components.
If the conditions we observe at a given date have been associated with positive market returns in a significant plurality of models and data-samples, we have positive expected returns and low uncertainty - a reasonable basis to accept market risk. If the average expected return is positive, but with a great deal of variability and many negative outcomes among individual models, we have positive expected returns but high uncertainty - which warrants a positive but more restrained exposure to market risk. If the average expected return is negative, and particularly if the ensemble of models is uniformly negative, accepting market risk is not supported by the evidence.
In hindsight, the points where the ensemble suggests significantly different positions than we took in practice were late-2008, when they were even more defensive than the limited exposures we accepted, and in 2009 through about April 2010, when the ensembles were generally more constructive. Frankly, this approach would still have rejected a material market exposure during the recent period of quantitative easing - the historical tendency of the market to generate poor average returns in overvalued, overbought, overbullish, rising-yields conditions is simply too strong. So with minor exceptions, our experience over the past year would have been about what it has been. But then, had our present approach been in hand since 2008, I doubt that we would be as uncomfortable with the modest net loss that we've experienced since early 2010 in Strategic Growth.
While the S&P 500 remains below its 2007 market peak, it is clear that investors are excited at the amount of ground that they have recovered thanks to extraordinary government interventions. With regard to the future course of the market, we don't get the luxury of certainty. The best we can do is to estimate probable returns, and the likely range of uncertainty. When we look over the past two decades, the highest points of measured uncertainty were in 1998 during the Asian crisis and the collapse of Long Term Capital Management, late 2001 just after 9/11, 2008 following the Lehman collapse, and summer 2010 just before the Fed launched QE2. Presently, the expected return estimates are negative on average, and are nearly uniformly negative across dozens of ensemble components. So we expect negative returns, with little uncertainty about it. A further improvement in market action, without a surge in bullish sentiment, would introduce more dispersion into expected outcomes and could move us to a moderate, if transitory market exposure. Here and now, we are defensive.
The past few years have been excruciating for investors. For buy-and-hold investors, the discomfort was concentrated at the front-end. For us, the discomfort has been on the back half. None of us gets a do-over, so the real question is how well we are prepared to deal with future market opportunities and uncertainties. I believe that we are well equipped.
The benefit of controlled risk and the avoidance of deep drawdowns is that it is often possible to recover lost ground rapidly, particularly relative to a passive buy-and-hold. Regardless of the course of the market in the coming months, my expectation is that we will see steep chutes in the coming years, and that there will be much greater success to be had from taking a future ladder at a low rung than attempting to climb the present one at elevated levels. From the simplistic level of discourse we observe in the investment markets, and the lack of concern for disciplined process and effective risk control, it is not clear that investors are broadly prepared to navigate the landscape ahead comfortably.
