October 19, 2003
John P. Hussman, Ph.D.
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Learning the Wrong Lesson
It's possible to have a great deal of experience, and yet to learn nothing. Early astronomers had this problem. They spent their lives watching the cosmos, and believed that as the Sun and the planets circled Earth, the planets would occasionally slow down, stop, and even move backwards for a while (“retrograde motion”) before continuing on their way around Earth.
Investors have got this problem too. They keep looking at the stock market as if it revolves around them; that it exists to make their investments profitable, regardless of what price they pay. And they continue to learn the wrong lessons from their investing experiences.
During the market bubble of the late 1990's, investors began to believe in the concept of free money. There was no room for the belief that the market's advance was irrational or overly optimistic. Investors didn't consider their motives to ask whether they were investing or speculating.
As investors gained experience with a rising market driven by their own unchecked, unexamined speculative impulses, they learned the wrong lesson. That lesson, they believed, was that “valuations don't matter anymore.” The lesson they should have learned was that “valuations temporarily don't matter when investors' speculative impulses are unchecked and unexamined.” Had they learned that lesson then, many investors might have greater financial security now.
Several weeks ago, James Glassman (of Dow 36,000 fame - or infamy) made an unbelievable remark. The lesson of the bear market, he said, was that investors never know when the market will turn around and advance, so they should never sell stocks in the first place. If that is indeed the lesson that investors have learned, they are in for an excruciating re-education. The price/peak-earnings ratio is now approaching 20 (a level which, except for the recent bubble, was seen only at the 1929, 1972 and 1987 speculative peaks). If investors learned anything from the recent bear market, it has nothing to do with value.
The only way to learn the right lessons is to simply look – without coloring reality or filtering it through biases like “the average economic expansion lasts for so and so” or “the average bull market advances by such and such.” Looking carefully, it is evident that neither the market's valuation nor the condition of the U.S. economy is typical. The market is at valuations that have historically characterized bull market extremes , not early bull market advances; past bull markets typically began at a price/peak earnings multiple below 9, rising to about 11 in the first year. The U.S. economy is dependent on the largest continuing inflow of foreign capital (current account deficit) in its history; every prior economic expansion began with a current account surplus where the U.S. had enough savings not only to finance its own investment, but also to invest abroad.
The Market Climate for stocks remains characterized by unusually unfavorable valuations and moderately favorable market action. As of last week, the Strategic Growth Fund continued to be fully invested in a diversified portfolio of stocks, with about half of that portfolio hedged against the impact of market fluctuations. We're still seeing fresh divergences in market action, but we would have to see substantially more internal deterioration to justify a fully-hedged stance.
In addition to our own proprietary measures, we're seeing some erosion in publicly known measures of market action. For example, the McClellan Oscillator (an indicator based on the number of advancing and declining stocks) was much more subdued than the major indices during the recent rally, and had an unusually quick plunge last week. The DecisionPoint Participation Index (which measures the number of stocks participating in market advances and declines) has also steadily deteriorated in recent weeks. Lowry's reports that the number of stocks above their 10-day moving averages has been contracting, despite advances in the major indices. Taken together, these measures provide some short-term evidence of deteriorating internals. The quality of market action is certainly important to monitor, but it remains moderately favorable for now.
In bonds, the Market Climate remains characterized by modestly favorable valuations and modestly favorable market action. Last week's decline in bond prices, combined with other data, was sufficient to warrant a modest increase in our holdings of long-term Treasury bonds. At present, the duration of the Strategic Total Return Fund is about 7.6 years, meaning that a 1% (100 basis point) move in interest rates would impact the value of the Fund by roughly 7.6%.
My impression is that the U.S. dollar has become somewhat oversold. There's an almost universal sentiment that the dollar is headed lower. While I generally agree with that view, markets are seldom so accommodating, and it would not be surprising to see the typical rally - “fast, furious and prone to failure” – to clear the oversold condition. That's not a forecast, but investors – particularly in precious metals - should be alert to that possibility.
As always, we tend to provide liquidity to the market by buying higher ranked securities on short-term weakness and replacing lower ranked holdings on short-term strength. Evidence of fresh U.S. economic weakness would currently be a favorable development from the standpoint of precious metals stocks. So while we remain on the sidelines of that market, we would be inclined to establish new positions on a sufficient price decline combined with fresh indications of economic weakness.
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