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February 9, 2004

Eat More Hay. Ten Million Horses Can't Be Wrong.

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

In October 1999, a few months before the recent stock market bubble peaked at Nasdaq 5000, Alan Greenspan brushed off concerns that stocks were overvalued with the following statement:

“To anticipate a bubble about to burst requires the forecast of a plunge in the prices of assets previously set by the judgments of millions of investors, many of whom are highly knowledgeable about the prospects for the specific investments that make up our broad price indices of stocks and other assets.”

To anybody with a firm grip on market history, that statement was great entertainment. It reflected exactly the sentiments that existed just before the 1929 Crash. As J.K. Galbraith wrote in his book The Great Crash, 1929, the influential Joseph Lawrence of Princeton also defended the market's valuation at the time, saying:

“The consensus judgment of the millions whose valuations function on that admirable market, the Stock Exchange, is that stocks are not at present over-valued. Where is that group of men with the all-embracing wisdom which will entitle them to veto the judgment of this intelligent multitude?”

Eat more hay. Ten million horses can't be wrong.

One of the important things to remember about markets is that they involve a certain amount of “feedback.” Rising prices encourage risk taking, and risk taking encourages rising prices. The converse is true for declining prices. If the feedback is particularly strong, you can get bubbles and self-fulfilling plunges, but most of the time, feedback simply reinforces existing trends without destabilizing the market.

Still, that feedback means that when prices are high, you can be certain that a great number of investors are convinced that prices should be high. When prices are low, you can be certain that a great number of investors are convinced that prices should be low. For that reason, relying on consensus views is rarely a useful investing strategy.

We occasionally receive notes about this fund holding or that, noting a variety of difficulties and a consensus of negative views about the security. Our response is simple – it is not typical for great value stocks to be well-liked. To the contrary, securities that are highly regarded by the consensus are often those that are priced for perfection, and are at risk for devastating losses if disappointments arise.

All of this came to mind as I read a recent article in the Wall Street Journal, reassuring investors that despite high valuation multiples, stocks might not be overpriced:

“To the relief of those who think stocks are fairly priced, however, the numbers are still lower than at the height of the bubble. In early 2000, the Nasdaq 100 traded as high as 165 times trailing earnings.” The article then quoted the calming opinion of a money manager, saying “I don't think we necessarily have to take it to excess this time.”

Has this become our standard? Have investors really come to tolerate anything short of the most extreme valuations in history?

P/E Ratios, Apples, and Oranges

On the basis of price/peak-earnings (popup: Why we use peak earnings), the S&P 500 currently trades at a multiple of nearly 22. Except for the year 2000 bubble peak, the highest multiples seen historically were in 1929, 1972 and 1987, each at no higher than 20 times peak earnings.

Of course, it has become fashionable to base P/E multiples not on reported earnings, but on estimates (always excessively optimistic) of future operating earnings. On that basis, the forward operating P/E is about 18, a figure which is always reported along with a statement that the historical average P/E is about 15. On that measure, analysts argue, valuations might be a little rich, but the difference can be explained away based on interest rates and the like.

I've always had a particular disdain for operating earnings, which do not adhere to generally accepted accounting principles and can be disturbingly arbitrary. Worse, as Cliff Asness of AQR Capital ( www.aqrcapital.com ) notes, the “historical average P/E of 15” isn't based on operating earnings, but on trailing earnings. Since forecasted operating earnings are generally much higher than trailing earnings, P/E ratios based on forecasted operating earnings are invariably lower than P/E ratios based on trailing earnings. Asness writes:

“Despite this, many bullish commentators blithely compare today's forecasted operating P/E to the historical average trailing P/E. They are trying to pull a fast one. The historical median “forecasted operating” P/E has been 12.1 since 1976 so the current figure is indicating that stocks are not a little, but a lot more expensive than the norm for the last 28 years.

“Furthermore, the 1976-2003 period was marked by higher than normal valuations. Consider that the median trailing 10-year P/E is 16.9 over the 1976-2003 time period, but when you go back to 1871 it falls to 15.4. Therefore, it is not a big leap to guess that the true long-term median “forecasted operating” P/E would be about 15.4/16.9 lower, or about 11.0, if we had that data further back in time.

“Therefore, today's “forecasted operating” P/E is dramatically higher than our best guess of a comparable long-term historical average. Basically, in an honest comparison, not playing fast and loose with the numbers, P/Es of any stripe are very high versus history (and please don't stare straight at dividend yields or you might go blind).”

Cyclical vs. Secular

So valuations are problematic for the market. Still, as we are always careful to note, overvaluation does not imply that stocks have to decline in the short term. Rather, overvaluation implies that stocks are priced to deliver very disappointing long-term returns.

Though I don't use the terms “bull market” and “bear market” in any practical way (for instance, trying to decide whether the market is in one or the other, which is fruitless), the terms can be useful shorthand. It is difficult to imagine that the recent bear market was “it” in terms of clearing the excesses of the bubble. More likely, the year 2000 peak ushered in a “secular bear market.” That's not a single bear market, but a series of full market cycles – a “cyclical bear market” followed by a “cyclical bull market” – in which each successive bear tends to settle at lower and lower levels of valuation. Historically, secular moves involve 3 or 4 full market cycles. At the end of a secular bear, stocks achieve a final and durable low (think 1982) that often ushers in a new secular bull. Historically, these puppies have been about 17-18 years in duration.

From that perspective, what we saw in the 2000-2002 “bear market” wasn't a final purge of excesses, but the first of a series of bear markets. We've now seen a good, solid cyclical bull market to follow, but one that has taken valuations back to 1929, 1972 and 1987 category extremes (indeed, price/dividend and price/book multiples far exceed anything seen at those prior extremes). It's certainly not necessary for stocks to immediately roll back into a new cyclical bear market, but the potential – even probability – that this move could be aging is something that investors should not ignore.

In short, buy and hold investors have a problem. Stocks are priced to go nowhere over the next decade, but they are almost certain to go nowhere in an interesting way. With valuation multiples currently very extreme (and inexplicable on a historical basis even factoring in interest rate conditions and the like), investors should remind themselves that further market gains would be based on continued interest by investors to take risk (speculative merit), not because stocks represent an attractively priced stream of future cash flows (investment merit).

Market Climate

The Market Climate for stocks remains characterized by unusual overvaluation, but still moderately favorable market action. In the Strategic Growth Fund, our investment position continues to allow for a very broad range of outcomes. The Fund remains fully invested in a widely diversified portfolio of stocks, with about half of that exposure hedged against the impact of market fluctuations. In addition, we continue to hold a “straddle” – both put and call options – and added to the call side on the market weakness early last week.

Essentially, a substantial market decline would kick in the put side of that straddle, taking the Fund to a roughly 70% hedged position (meaning that we would expect to be exposed to only about 30% of any extensive market loss), while we would expect to participate almost fully in a substantial market advance here. The primary risk would be a sideways movement in the market in which market volatility is less than the volatility priced into the options. In that event, the Fund would risk “time decay” of just over 1% of assets, which is what we have invested in that straddle here. Again, I wouldn't advise doing this at home, since the positions have to be managed carefully in order to exploit the time premium we've purchased, but this is fairly standard stuff for us.

In the Strategic Total Return Fund, we added some additional exposure in precious metals shares on price declines early last week. Our exposure in this area is still only modestly above 5% of assets, but it does provide useful diversification not linked directly to interest rate movements. The overall duration of the Fund is just under 2.5 years, meaning that a 100 basis point move in interest rates would be expected to impact the Fund by about 2.5% on the basis of bond price fluctuations.

S.A.P.s

A final note on the employment report, which showed a disappointing 112,000 non-farm jobs created in January. The Department of Labor had this interesting line in the report (italics added):

“Retail trade employment increased by over 76,000 over the month, after seasonal adjustment. The industry lost a total of 67,000 jobs in November and December. Weak holiday hiring in general merchandise, sporting goods and miscellaneous stores meant that there were fewer workers to lay off in January, resulting in seasonally adjusted employment gains for the month.”

That's almost Orwellian. Essentially, the seasonal adjustment adds jobs to the January figures to correct for normally heavy losses of temporary jobs after the holidays. But since there were so few of these jobs actually created during the holidays, those January layoffs didn't occur either. As a result, the seasonal adjustment results in a gain of 76,000 fictional jobs for January. These aren't real jobs because they aren't real people. Let's call them “Seasonally Adjusted People.”

New from Bill Hester: The Battle Between Speed and Stability


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