Hussman Weekly Market Comment: The Third Law of Randomness

On March 5th, our estimates of prospective return/risk conditions in the stock market fell to the most negative 2.5% of all historical observations (see Warning - A New Who's Who of Awful Times to Invest). On March 26th, those estimates fell to the most negative 0.5% of historical observations (see A False Sense of Security), and have remained in that range since that time. Market conditions have now been in this hostile set of conditions for 16 weeks. This situation might continue on to 20 weeks, or to 24 weeks. It might continue longer - though I doubt it. What we do know, however, is that when conditions have been similarly negative historically, the S&P 500 has plunged at an annualized rate of over 40%, distributed over some of the most awful outcomes in market history.

How do we know that the present instance will turn out similarly? We don't. Proper investing doesn't rule out randomness and unpredictability, particularly when it comes to individual events. It instead diversifies against randomness both across holdings at each point in time, and across time by repeatedly acting on the basis of averages instead of individual forecasts. Random events behave predictably in aggregate even if they're not predictable individually - a fact that Charles Seife calls the Third Law of Randomness. "To say something is random is not equivalent to saying that we can't understand it. Far from it. Randomness follows its own set of rules - rules that make the behavior of a random process understandable and predictable. These rules state that even though a single random event might be completely unpredictable, a collection of independent random events is extremely predictable - and the larger the number of events, the more predictable they become."