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February 17, 2004

Too Much of a Good Thing

John P. Hussman, Ph.D.
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There's a saying that goes “History doesn't repeat itself. Only we can do that.”

With the stock market trading at nearly 22 times peak earnings (the historical median is 11), and 62 times dividends (the historical median is 26); a market in which corporate insiders are liquidating stocks at upward of 5.7 shares sold for every share purchased (Vickers), while just 14.6% of individual investors (AAII) and 19.2% of investment advisors (Investor's Intelligence) are bearish, it is clear that investors are already far along the path to repeating their mistakes.

Last month, new inflows into mutual funds hit $40.8 billion – the highest figure on record. One would think that this might have bullish implications, at least over the short run. But then, one would be wrong. Mutual fund inflows are statistically correlated with movements in the stock market, but they are both a lagging and a contrary indicator. Specifically, mutual fund inflows are positively correlated with past stock market movements, and negatively correlated with subsequent stock market movements. The strength of these correlations is strongest about 12 months in either direction. So for example, strong gains in the stock market over the prior 12 months are reliably associated with above average mutual fund inflows, which are in turn associated with below average stock market returns over the following 12 months.

Interestingly, this isn't just a case of strong market returns in one year being followed by weaker returns the next. The mutual fund inflows do add independent explanatory power. So for example, if mutual fund inflows are stronger than can be explained simply by the past year's market strength, the market's performance over the following 12 months also tends to be weaker than can be explained simply by the past year's market returns. These correlations aren't strong enough to make reliable market forecasts, but it's clearly incorrect to interpret heavy mutual fund inflows as bullish evidence. Probably the best conclusion to draw is simply that the recent data on mutual fund inflows are consistent with the extremes we see in other contrary indicators such as bullish sentiment.

Fundamentals don't drive short-term market direction

Nothing in these remarks should be interpreted as a forecast of impending market weakness, particularly over the short term. As I frequently emphasize, overvaluation does not imply poor short-term returns. Rather, overvaluation means only that stocks are priced to deliver disappointing long-term returns. What matters in the short-term is investor's willingness to take risk. That's a psychological preference, and it's impossible to stand in front of investors saying “No, enough is enough.” All we can do is attempt to read investor's risk preferences out of market action. Hands down, the worst losses for stocks have historically occurred when valuations were elevated and investors became skittish toward risk, as evidenced by market action.

In my view, the major stock market indices have little investment merit from the standpoint of valuations, but there still enough speculative merit to warrant some exposure to market risk. What is essential, however, is the recognition that we are taking risk purely on the basis of speculative merit, that we have already established a line of defense against the potential failure of that speculative merit, and that our exposure to risk is modest and proportional to the return/risk profile that we currently observe.

Mistaking earnings trends for investment value

Unfortunately, many investors and analysts honestly seem to believe the idea that stock valuations are justified by fundamentals, and that at worst, stocks have run up a bit too fast over the short run.

That's where we part company. Investors' willingness to ignore value is based on a mistaken focus on earnings trends rather than levels; a belief that so long as earnings and the economy are improving, the actual prices paid for stocks will be justified by those fundamentals.

Unfortunately, this is the same faith that investors displayed at many market peaks throughout history, not least in 1929. As Benjamin Graham and David Dodd later wrote in their 1934 book, Security Analysis:

“The 'new-era' doctrine - that 'good' stocks (or 'blue chips') were sound investments regardless of how high the price paid for them -- was at bottom only a means for rationalizing under the title of 'investment' the well-nigh universal capitulation to the gambling fever… Why did the investing public turn its attention from dividends, from asset values, and from earnings, to transfer it almost exclusively to the earnings trend? The answer was, first, that the records of the past were proving an undependable guide to investment; and secondly, that the rewards offered by the future had become irresistibly alluring ... The notion that the desirability of a common stock was entirely independent of its prices seems incredibly absurd. Yet the new-era theory led directly to this thesis. If a stock was selling at 35 times the maximum recorded earnings, instead of 10 times its average earnings, which was the pre-boom standard, the conclusion to be drawn was not that the stock was too high but merely that the standard of value had been raised. Instead of judging the market price by established standards of value, the new-era based its standards of value on the market price.”

That willingness of investors to turn their attention “from dividends, from asset values, and from earnings, to transfer it almost exclusively to the earnings trend,” is something that we need to watch carefully. This doesn't mean that stock prices have to turn down anytime soon. But it is dangerous to assume that stocks are priced to deliver strong long-term returns to buy-and-hold investors.

Too much of a good thing

Still, market action remains generally positive for stocks. As I've noted frequently, a market in which investors have a robust willingness to take risk is a market where most stocks, industries, and security types will usually be advancing, with few clear or persistent divergences.

Looking at the data on the NYSE, fully 93% of stocks on that exchange are above their 30-week moving averages. There is also a broad uniformity across industry groups, and both corporate and Treasury bonds have been holding firm. Sure, we've seen some initial causes for concern, such as the recent weakness in the Dow Transportation Average, as well as some early fragility in the industry picture, but overall, market action seems strong. So why worry about those pesky valuations?

Simple. We're seeing a bit too much of a good thing here. Specifically, it's a good thing to see uniform market strength. But too much of that suggests an overextended and potentially vulnerable market condition.

Historically, markets that have been both highly overvalued and technically overextended have also been markets with the potential to decline a good distance before investors recognize that there is anything meaningfully wrong. After all, any early decline at this point would almost surely be accepted as a normal correction, given the advance we've seen.

And while I have a certain amount of confidence that our own measures of market action would identify a shift in investors' risk attitudes fairly early, that confidence is not nearly strong enough to justify a fully invested or unhedged investment position.

Accordingly, the Strategic Growth Fund is already about 50% hedged against the impact of market fluctuations. Based on certain short-term conditions, we also hold a “straddle” in both call options and put options here, because the probable volatility in the market over the short run (including the potential for a powerful short-term advance, as well as a breakdown) is likely, in my view, to exceed the volatility implied in those options.

Again, it is important to emphasize that the comments here relate to risk (which I view as substantial) and not probable short-term market direction (on which I have no opinion). Nothing in these comments should be interpreted as a forecast of oncoming weakness in the short-term. Rather, these comments are intended to point out the potential for substantial market losses in the event that investors' appetite for speculation begins to diminish at these levels of valuation.

Meanwhile, it's not necessary to make short-term forecasts. Indeed, our current position is very tolerant of short-term uncertainties. In the event of a strong advance, I would expect the call options to enhance our participation. In the event of a strong decline, I would expect the put options to reduce our exposure to market fluctuations to even less than 50% of the market's volatility. A flat market without substantial volatility would result in a certain amount of time decay that we could not recover through active management of that position. That potential time decay amounts to about 1% of assets here.

Market Climate

In stocks, then, the Market Climate remains characterized by unusually unfavorable valuations but still moderately favorable market action. We've responded to the level of valuations, a variety of early breakdowns in market action, and the overextended nature of the recent advance, but overall, we would still expect to benefit from further market advances, and to participate in at least some portion of any market decline that might emerge at present.

In bonds, the Market Climate remains characterized by modestly unfavorable valuations and modestly unfavorable market action. Bond investors are essentially playing Chicken with the Fed here, trying to stay on the road until the last moment before a head-on collision. Historically, the bond market has generally gone off the road immediately before the Fed started a tightening cycle. The belief that the Fed has time on its hands has encouraged bond investors to continue the “carry” trade – borrowing at low short-term rates and investing in higher yielding long-term bonds.

In our view, that carry trade actually does have some merit, given the steepness of the yield curve here. But our estimate of the risk is much higher than the market seems to assume. The risk here is not simply that the Fed tightens, but that market forces such as dollar weakness or inflation pressures could affect market yields even in the absence of Federal Reserve action, prompting a reluctant and lagging response by the Fed.

Probably the main factor that could shift us to a more constructive position in Treasuries would be a widening of credit spreads. The compensation offered by the corporate bond market for credit risk has become extremely thin. If we were to see that widen, it would be an important indication of potential economic weakness, as well as an indication that investors had become more averse to credit risk. Both factors would be favorable toward Treasuries.

At present, however, the prevailing evidence holds the Strategic Total Return Fund to a relatively short duration profile of less than 2.5 years (meaning that a 100 basis point move in bond yields would be expected to affect the Fund by less than 2.5% on account of bond price fluctuations). We continue to hold moderate investments in precious metals shares and utilities, as well as Treasury Inflation Protected Securities. We would be inclined to increase our investments in these alternative investments on price weakness.


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