January 5, 2004
A Lemon With a Nice Paint Job Is Still a Lemon
Over the years, I've emphasized the fact that fundamentals don't necessarily matter over the short-term, but they invariably shape what happens over the long-term. Despite the current excitement in the stock market and the economy, the simple reality is that stocks remain priced to deliver unsatisfactory long-term returns, and the combination of low savings and high debt burdens largely ensures that consumption and investment growth is likely to fall far short of prior recoveries, despite short-term heat from tax rebates and mortgage refinancings. Short-term growth does not lift long-term constraints – it simply defies them for a while.
Presently, there's no particular reason why the current speculative tone in the markets and the economy cannot be extended even further. But it is very likely that any further gains that do emerge will ultimately be surrendered. We're not nimble enough to pinpoint major turns in the markets, and we know it. We respond to the conditions that we observe at each point in time. Accordingly, we've already partially hedged our exposure to market fluctuations, though we would still expect to benefit from further gains in the stock market if they emerge.
Advisory bullishness and insider bearishness remain extreme
Investor's Intelligence reports that “sentiment readings are the worst since 1987 for advisors, and now just below the worst ever for insiders. Insiders are now selling just under seven shares for every share bought.” Investment advisory bullishness has been above 50% and bearishness below 25% for thirty-five consecutive weeks. In 1987, bullishness was above 50% for twenty-three weeks, and even those were not consecutive. The percentage of industry groups in uptrends is an extremely overbought 92.8%.
That strong uniformity of industry uptrends confirms what we observe from our own measures of market action, and is an indication that investors remain willing, for now, to take speculative risk. This speculative merit - alone - is why we continue to hold a generally positive (though moderate) exposure to market risk. However, given that market action is also extremely overbought, we also hold a small “contingent” position in put options (a fraction of 1% of assets) sufficient to hedge another 20-25% of our market exposure in the event of an abrupt decline.
In short, the market continues to have a favorable, but increasingly precarious speculative tone.
“People are most credulous when they are most happy” – Walter Bagehot
On the valuation front, one of the classic signals of an emergent bubble is the appearance of new measures of valuation to justify the elevated prices. John Kenneth Galbraith noted this phenomenon decades ago in his book The Great Crash 1929: “It was still necessary to reassure those who required some tie, however tenuous, to reality. This process of reassurance eventually achieved the status of a profession. However, the time had come, as in all periods of speculation, when men sought not to be persuaded by the reality of things but to find excuses for escaping into the new world of fantasy.” We saw this during the late 1990's in the form of valuation measures based on “hits” and “eyeballs,” Harry Dent's demographic models, and incredible contortions of finance theory like Glassman and Hassett's Dow 36,000.
Not to be outdone, the recent advance has engendered a new fantasy valuation approach from the latest of Arthur Laffer's liquor-soaked cocktail napkins, dutifully featured this week in Barron's. Laffer reports that after calculating the S&P 500 P/E ratio using an earnings measure that isn't actually based on S&P 500 earnings, adjusting that P/E using interest rates of a far shorter duration than are relevant for pricing stocks, and modifying that adjusted P/E with numerous ad-hoc assumptions about tax impact, it turns out that the actual P/E ratio on the S&P 500 is ostensibly 3.3 (three point three - that's not a typo). Notably, Laffer's cartoonish P/E ratio was already below-average at the year 2000 bubble peak, which is a nice thing to know when you're about to lose half your money.
As Glassman and Hassett argued with a straight face, if earnings were dividends, and growth needed no investment, and stocks were bonds, and risk was safety, the Dow's P/E could be 100. To seriously entertain valuation theories like these, or even variants of them, requires the willingness to make endless substitutions that interchange fact with fiction. To any serious analyst of the markets, the entertainment value in doing this runs out very quickly.
On the basis of price-to-peak-earnings, the S&P 500 now trades at a multiple of 21, which is higher than the final peaks of 1929, 1972 and 1987. Moreover, those prior peak earnings (achieved in 2000) were on the basis of unusually strong profit margins and return on equity. In other words, those earnings were out-of-line with revenues and book values (not to mention dividends) observed at the same point. On the basis of a wide variety of fundamentals - the most relevant to us always being linked to the generation of free cash flow - the market has been more richly valued during only one other span of history, which was the approach and early decline from its bubble peak in 2000.
Reported cash flow has certainly picked up in recent months, but I remain skeptical of the source. Charles Mulford, who oversees the Financial Analysis Lab at Georgia Tech agrees: “At least some of the recent improvement in cash flow is from liquidating the balance sheet; it is not earnings produced. That kind of growth is not sustainable.”
This is not to say that stocks must decline over the short run. In stocks, the Market Climate remains characterized by unusually unfavorable valuations yet still moderately favorable market action. It is essential to understand that regardless of overvaluation or overbought conditions, there is no hard or natural limit to investors' speculative impulses. You can't stand in front of investors and say, “no, that's enough, you're truly insane, really, and it's going to end badly, so that's enough.” The only thing you can do is to carefully monitor the strength of those speculative impulses as they are revealed through the quality of market action, and to allow for the possibility (though not the probability or expectation) that this speculation might end abruptly. Having done this, we remain comfortable being about 50% hedged against market fluctuations in the Strategic Growth Fund, while adding a tiny “contingent” put option position amounting to less than 1% of assets.
In bonds, the Market Climate remains characterized by moderately unfavorable valuations and moderately unfavorable market action, holding us to a short-duration stance of less than 2 years (so a 1% or 100 basis point move in interest rates would be expected to impact the value of the Fund by less than 2% on account of bond price fluctuations). In addition to short-dated Treasury securities, which account for an appropriate (but not typical) share of nearly half of the Strategic Total Return Fund, we continue to hold a variety of alternatives to straight bonds, including Treasury Inflation Protected Securities and utility stocks. We also hold modest positions in foreign government notes and precious metals shares, though these positions are the most subject to change from time to time. In any event, the potential for upward pressure on interest rates is substantial here, and a short-duration position is precisely what the Market Climate in bonds demands.
The economy – burning lighter fluid, but still no bed of hot coals
On the economic front, it's clear that the fourth quarter will show strong GDP growth, which was predictable on the basis of inventory rebuilding. The real question, given that stock prices have thoroughly discounted a strong economic boom, is whether recent growth is sustainable at the widely projected 4-5% rate for the year ahead (we don't rely on forecasts like that, but for what they're worth, our estimates come in closer to 2.5% real GDP growth for 2004).
The always thought-provoking analysts at Bridgewater note that even the growth we've seen in recent months has been largely driven by last summer's tax rebates:
“Spending has moved with after-tax income, but to a lesser degree. The fact that spending rose less than after-tax income in July and August implies that consumers did not spend all of their refund checks (we estimate that they spent roughly 60% of the checks then). We also see this in the higher than normal savings rate in those months. But in the past couple of months the savings rate has been lower than normal, implying that consumers are still spending some of their tax cuts and tax refunds, providing a boost to spending. In other words, the tax refund impact has not yet cleared the system… It is still important to keep in mind that this expansion is very unlikely to be as strong or as long as the one in the 1990's which was driven in large part by a 4% decrease in the savings rate (it is more likely that the savings rate will move in the opposite direction [here]).”
Bridgewater also observes “corporate borrowing has yet to turn around. Typically borrowing leads investment, but so far companies are financing their investment from profits. With [credit] spreads at five year lows and not much higher than before the Asian/Russian crisis, it would be a bad sign if corporate borrowing doesn't pick up in the first couple of quarters of 2004. Commercial loan growth remains negative, as it has been for two and a half years. And commercial paper issuance has also dipped into contraction after improving earlier in the year.”
As I've noted before, the weak level of domestic savings and the gaping current account deficit all but ensure that neither consumption nor gross domestic investment will grow at rates anything comparable to those of past expansions. What we're seeing right now in the GDP and Purchasing Managers figures is the impact of helicopter money – a one time tax jolt combined with an historic surge in mortgage refinancings (which have begun to plunge more recently). All investment must be financed by saving – an accounting identity unaffected by monetary or fiscal policy – so the growth that we see in capital spending (which I do anticipate to some extent) is likely to come at the expense of housing investment in the quarters ahead, with relatively stagnant growth in overall gross domestic investment.
The bottom line
In short, I continue to view the fundamental underpinnings of the stock market and the economy as far weaker than Wall Street appears to believe. Still, there is clearly a speculative element that is playing itself out, and there is no particular reason why it has to exhaust itself quickly. What emerges from this is a market that is priced to deliver very unsatisfactory long-term returns, but continues to hold some speculative merit. As our recent addition of contingent put options should suggest, we aren't willing to accept that speculative risk without carefully considering the potential losses as well as the potential gains. Still, we remain positioned in a way that will primarily benefit from further advances in the market.On a relative basis, the winning themes over the past year were low-quality, small-cap, high leverage, and speculative growth. That's not an unusual tendency for a market advance right out of the gate, but as I noted fairly early in the year, investing shareholder capital in low quality, weak balance sheets and overvalued securities is not an element of our discipline. Fortunately, our approach has performed as intended without reaching into those gutters. While I don't rely on particular forecasts or “style” tendencies, it's at least worth mentioning that the fourth year of a Presidential term tends to be particularly kind to value, and I believe that our holdings heavily reflect that characteristic. In an overvalued and potentially vulnerable market, that's exactly where we're comfortable standing.
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