March 22, 2004
A Gathering Storm
Near the peak of the stock market bubble a few years ago, as many technology stocks were soaring, Yale economist Robert Shiller appeared on CNBC, detailing his views about the overvaluation of the U.S. stock market. Answering a question about what investors or policy makers could do to avoid the consequences of the bubble, Shiller noted that while certain investors could defend themselves, it was impossible for the market, in aggregate, to do so. Summing it all up, he said, “It's just an unfortunate situation.” I'll never forget that phrase, and the baked-in-the-cake inevitability that it implied.
Examining the condition of the U.S. economy with regard to personal, corporate, federal and international indebtedness, the same conclusion is unavoidable. It's just an unfortunate situation.
Amid the glib opinions of CNBC guests that the economy is expanding, the unrelenting déjà vu that jobs are just around the corner, and the misplaced confidence that stock prices will follow corporate earnings higher, there is only faint recognition of how profound the U.S. debt problem is, and how ineffective standard fiscal and monetary policy tools will be in escaping its consequences.
At the national level, the U.S. continues to run the deepest current account deficit in history. As I've noted previously, the savings-investment identity implies that “adjusting” this deficit must, by definition, involve growth in domestic investment, government spending and consumption that falls short of U.S. GDP growth. To the extent that government spending does not contract, and consumption tends to be the most stable form of economic activity, it's clear that the bulk of this adjustment will occur on the investment side, through relatively disappointing growth in U.S. domestic investment – regardless of the rate of GDP expansion. Most likely, we'll see modest increases in capital spending, combined with contraction in residential investment such as housing.
The reason that the U.S. has been able to run these extreme current account deficits can be traced directly to China and Japan, whose governments have accumulated U.S. Treasury securities in the past few years at rates that can only be described as bizarre, in attempts to support the U.S. dollar and hold down the values of their own currencies. The “benefit” of this to the U.S. has been the ability to finance deep federal deficits and maintain an abnormally skewed yield curve, with short-term interest rates at less than 1%. The Federal Reserve's ability to maintain a loose monetary policy (and negative real interest rates) without upward pressure on market interest rates is more attributable to foreign accumulation of Treasuries than to any particular skill or even intent of the FOMC.
Meanwhile, individuals and corporations have fully exploited the steepness of the yield curve. Corporations have swapped a great deal of debt into floating-rate structures (see Freight Trains and Steep Curves), while floating-rate borrowing has exploded to more than one-third of all recent mortgage originations, according to the FDIC, even while the equity (and credit quality) of homeowners has plunged. All of this has opened corporations and individuals to unusual risk in the event that foreign governments slow their accumulation of U.S. Treasuries and short-term interest rates advance.
Turning to financial intermediaries, CSFB recently issued a disturbing report warning of the large and growing imbalance in the U.S. interest rate options market. The net position in global interest rate options written by dealers (including FDIC insured banks like J.P. Morgan, Citigroup, and Bank of America) has exploded from a neutral position in 1999 to a net short position of -$888 billion in notional value.
“The mortgage market has gone from being about half the size of the Treasury market in the mid 1990's to about 20% bigger than the Treasury market today. This means a lot more Treasuries are being bought and sold to keep mortgage portfolio durations stable. The source of much of the interest rate risk is the prepayment option embedded in fixed rate mortgages. Falling interest rates entice homeowners to refinance, and this reduces the duration of outstanding mortgage bonds. Owners of mortgage securities generally seek to maintain stable portfolio duration and therefore buy Treasuries to replace the duration lost by the refinanced mortgages. The opposite is true when interest rates rise. Holders of mortgage-backed securities are finding it very difficult to maintain a stable portfolio duration. Nowhere is this more evident than at Government Sponsored Enterprises (GSE's).”
“The GSE's (Fannie Mae, Freddie Mac) among others, have been busy trying to redistribute this prepayment risk to broker dealers, among others. One way they do this is by buying an OTC interest rate option. This explains why the notional amount of interest rate options purchased by Fannie Mae has increased from about $27 billion at the end of 1998 to a whopping $444 billion by September of last year. In a nutshell, an increasingly small group of dealers are taking on an increasingly large amount of prepayment risk. Their hedging creates a feedback loop because dealers, collectively, will tend to buy Treasuries when interest rates are falling and sell them when interest rates are rising. Simultaneous hedging by dealers has the capacity to turn a relatively small move in interest rates into a relatively large one. All of these factors helped amplify the move in interest rates last summer, when Treasury yields increased roughly 150 basis points and swap spreads almost doubled in a matter of weeks. Moves in interest rates are being amplified by the activities of broker dealers covering exposure to interest rate options. Volatility risk could translate into liquidity risk. This is a market structure that can play host to spillover risk and financial contagion.”
In short, the U.S. financial system has taken on a great deal of debt, default risk, yield curve risk and interest rate risk, all of which is sensitively dependent on the willingness of foreign governments to accumulate U.S. debt securities in unsustainably large quantities. Last week, Japan's finance minister noted “we cannot continue to intervene forever.” China is experiencing similar pressure to revalue the yuan (not the least of this pressure coming from well-intentioned but economically naïve U.S. politicians). As economist Herbert Stein famously said, “If something is unsustainable, it isn't likely to be sustained.”
It's just an unfortunate situation.
The Market Climate for stocks remains characterized by unusually unfavorable valuations and tenuously favorable market action. The Strategic Growth Fund remains fully invested in a diversified portfolio of stocks, with about half of that portfolio hedged against the impact of market fluctuations. In addition, we're holding a “contingent” put option position sufficient to remove an additional 45% of our exposure to market fluctuations in the event of a moderate to substantial market decline. The value of this position is currently less than 2% of assets, but it is an important element of our risk management here.
Stock valuations are again pushing 22 times prior peak earnings (outside the bubble's peak, the prior historical extreme was 20, which the market reached in 1929, 1965, 1972 and 1987). What strikes me about this is how little investors seem to understand the implications. From all evidence, investors seem to believe that stocks are currently in a “standard” bull market – one that typically lasts for a series of years and can be expected to reliably respond to earnings growth through further price increases. There is no historical basis for these beliefs.
Though I believe that bull and bear markets exist only in hindsight (not in observable experience), we can indeed look back in hindsight and examine their characteristics. What is immediately notable is that past bull markets historically began with prices at less than 9 times prior peak earnings, on average; that most began at less than the historical median of 11 times prior peak earnings; and that none began at a multiple above the historical average of 14. That is, except the advance that began in October 2002.
The current advance does not have the valuation earmarks of typical bull markets. Nor, as I have noted before, does the current economic expansion, which began not from a current account surplus as past expansions have, but with the deepest current account deficit on record. As such, this advance is also unlikely to end like typical bull markets end. It will most probably end (and may in fact be ending) like most “bear market corrections” end – with an abrupt “reversal” in market breadth rather than a gradual and prolonged flattening in the advance-decline line.
While our own measures of market action remain tenuously – and I stress tenuously – favorable, I noted last week that Dow Theory has already pronounced a new bear market, based on Richard Russell's authoritative interpretation of the theory (Dow Theory Letters). Despite my aversion to classifying market movements in “bull/bear” terms, Russell's views on this reversal are interesting: “What we're seeing is the death of an upward correction in a primary bear market, and this may be why the ‘normal' market top statistics (persistent weakness in the advance-decline line, weakness in interest-sensitive securities like bonds and utilities, expanding selling pressure in the Lowry's statistics) have been absent.”
In any event, the market is showing increasing signs of internal turbulence. In the context of extreme valuations, heavy bullish sentiment, persistent economic disappointments, and extreme insider selling, the deterioration we've seen in market action has already moved us to take “contingent” positions (less than 2% of assets in index put options) intended to remove the bulk of our exposure to market fluctuations in the event of a moderate-to-substantial market decline.
Because of the unusually high valuations that have accompanied this advance, the Strategic Growth Fund has been hedged to varying degrees against the impact of market fluctuations. It is important to emphasize that this is not standard bull market positioning for the Fund. Investors who have incorrectly concluded that the Fund “generally” takes a hedged investment stance, will “generally” lag bull market advances, or that it can be “generally” relied on to be a low-risk fund, should immediately and carefully re-read our Prospectus.
The Strategic Growth Fund is emphatically a growth fund, and has the ability to take fully unhedged and even aggressive investment positions. In a Market Climate characterized by favorable valuations and favorable market action (which encompasses the vast majority of early bull market periods), the Fund can establish leverage of up to 150% of assets. In order to limit the impact of adverse market movements, we can take that “leverage” only by investing a small percentage of assets in call options. While I do believe that the combination of favorable valuation and favorable market action is associated with below-average risk of loss, our exposure to market fluctuations in that Climate is likely to be substantial. As such, it will be impossible to characterize the Strategic Growth Fund as a “conservative” holding in such a Climate.
In short, the apparent “defensive” nature of the Fund since its inception is a function of the particular Market Climates we've observed during that period. The best way to understand the Fund as a long-term investment is to read the Prospectus. I care deeply about risk management, but ultimately, the objective of the Fund is to invest for long-term growth. I constantly look for opportunities to make hay when the sun is shining, and it would be incorrect to believe that the Fund will “generally” carry an umbrella even when the Climate does not indicate rain.
In bonds, the Market Climate is characterized by moderately unfavorable valuations but modestly favorable market action. Early last week, we took the strong advance in bond prices as an opportunity to shorten the portfolio duration of the Strategic Total Return Fund. Currently, the Fund's duration stands at about 2.5 years (meaning that a 100 basis point move in interest rates would be expected to affect the Fund by about 2.5% on the basis of bond price fluctuations). While there remains a modest amount of speculative merit in bonds resulting from benign inflation and relatively tepid economic pressures, that merit has to be balanced against increasingly unfavorable valuations and developing pressures for currency revaluation in China and Japan. I would be inclined to add to our positions in precious metals and Treasury Inflation Protected Securities on price weakness, but our present exposures in these bond market alternatives are comfortable here.
A final note - if you've missed Bill Hester's recent articles, click on the Research & Insight page and spend some time in the top section. The valuation charts he includes in Those Bargain Days are very instructive, and Bill's review of Peter Bernstein's AIMR presentation in The Future of Investment Management is required reading.
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