May 3, 2004
It's Dark, and We're Wearing Sunglasses
“It's a hundred six miles to Chicago, we got a full tank of gas, half a pack of cigarettes, it's dark, and we're wearing sunglasses.”
- Dan Aykroyd and John Belushi in The Blues Brothers
The lenses investors wear at any particular point in time affects how they see the world. Hand them the glasses they were wearing in 1999 and 2000, and they see a gleaming new economy on the horizon, built on infinitely rapid growth in technology (a few investors have retrieved those lenses from the trash heap of the dot-com collapse, and can be found lining up for the Google IPO, which isn't to say the stock won't have about 72 hours of fun). Whatever the color of the glasses they are wearing, investors tend to interpret the news of the day through those filters.
From the standpoint of our own Market Climate approach, I've long observed that the market's interpretation of news events is heavily conditioned on the particular Market Climate in effect. I've noted before that when the Market Climate for stocks is favorable, two things happen: the economic news tends to come in above expectations, and even negative news tends to draw a muted or even positive response from investors.
The opposite is true in hostile Market Climates. Economic news tends to come in on the disappointing side of expectations, and even favorable news gets a tepid response from investors.
There's a simple reason why this is true. Long-term economic growth and stock market fundamentals simply don't vary greatly over time (we know for instance, that S&P 500 earnings have grown at a rate of about 6% annually from peak-to-peak, regardless of whether we look back 10, 20, 50 or 100 years). And since stocks are a claim on a very, very long-term stream of cash flows, the sort of volatility we see in the economy and corporate earnings just doesn't matter much to the discounted value of those cash flows.
Let's do an intellectual exercise. Suppose that stocks currently deliver 2% in free cash flow to investors annually, and that those cash flows grow by about 6% annually over time (for a long-term total return of 8%). Even if we completely wipe out the first three years of cash flows – literally drop them to zero – the impact on the present discounted value of the entire stream is just -5.45%. So long as investors don't change their perceptions about long-term growth rates, or the long-term return that stocks should be priced to deliver, cyclical variability in the cash flows themselves has very, very little effect on stock values.
And there's the key. Stock market declines are simply not caused by disappointments in near term earnings and the economy. The real impact of any news event comes either from investor perceptions that the disappointments will continue indefinitely, or from changes in the risk premium that investors require in order to hold stocks over the long-term (the higher the risk premium demanded by investors, the lower the price).
This is why earnings disappointments in technology stocks typically sting much worse than disappointments in say, blue chip consumer stocks. Given the amount of competition and obsolescence in the tech industry, investors make very long-term inferences based on even small shortfalls in revenues and earnings. In contrast, earnings disappointments for the S&P 500 as a whole don't seem to propagate at all over the long-term. For that reason, annual returns on the S&P 500 are nearly uncorrelated with the rate of earnings growth in the prior, same or subsequent year.
So what drives returns in the stock market? In my view, there are two elements. First, valuation is important, but mainly in determining the very long-term return that stocks are priced to deliver. For any given set of future cash flows, the higher the price you pay, the lower the long-term return you get. This is an iron law of finance.
On the subject of valuations, Jeremy Grantham ( http://www.gmo.com ) recently made this instructive comment (note that he quotes valuation in the context of a long-term trend, not as a forecast or near-term target):
“Normal p/e (16x) on normal profit margins (6.0% on sales) produces a trend line or fair market value that still looks like 720 on the S&P 500 versus today's 1120. We could of course, be in a new paradigm of permanently higher p/e's. We know intellectually that new paradigms are possible despite none occurring yet at the asset class level, but hey, there's always a first time.”
Second, what matters is not the news, but the interpretation that investors place on it. That depends a lot on their willingness to take market risk. When investors have a robust willingness to take risk, they tend to respond to all news – good or bad – in a generally favorable way. When they are skittish toward risk, all news is essentially bad news.
A week ago, the CBOE volatility index dropped to 14, indicating a level of complacency far beyond anything we've seen in recent years. Insider selling has been extremely heavy for months. New issues and secondary offerings have rivaled those of the 2000 peak. Breadth (advances versus declines) and leadership (highs versus lows) are now rolling over in a very well-defined way. Interest sensitive securities have been considerably weak. A variety of industry groups have now moved from overbought extremes to clear breakdowns.
None of this means that stocks can't rally (indeed, we can generally expect that oversold conditions in this Climate will frequently, but unpredictably, be cleared by fast furious rallies that are prone to failure). Still, we now observe neither investment merit (favorable valuation) nor speculative merit (favorable market action) as a basis for taking stock market risk. We are not inclined to take risks that are not associated with sufficient expected return, so we have hedged our exposure to market fluctuations as completely as possible.
In short, based on our analysis of valuations and market action, investors changed their lenses last week, and our portfolios are aligned accordingly.
It's dark, and we're wearing sunglasses.
Last week, the Market Climate for stocks slipped decidedly into the most hostile condition we define – extremely unfavorable valuations, unfavorable market action, and hostile interest rate trends. This is not good. We are fully hedged. Investors in the Strategic Growth Fund need not take further action to reduce their exposure to market fluctuations because we have already done so. When we are fully hedged, our main risk, as well as our primary source of return, is the potential for the stocks we hold to perform differently than the indices we use to hedge. While this difference can be positive or negative on a day-to-day, week-to-week, or even quarter-to-quarter basis, it was the primary source of return in the Strategic Growth Fund between July 2000 and March 2003, which was clearly not a flat period for us.
The shift in Market Climate is already showing up in the market's response to news. On Friday, the Chicago Purchasing Manager's Index came out much better than expected, but the market's response was surprisingly weak. There are usually several ways to “spin” a particular piece of economic news, and in a negative Climate, investors usually choose the negative one. In this case, the strong Chicago PMI was actually “bad news” because it served to reinforce fears of Fed tightening. It will be interesting to see how the market responds to the upcoming April employment report this Friday.
In bonds, the Market Climate has also shifted, to a condition of modestly favorable valuations but now unfavorable market action. As a result, we cut the portfolio duration in the Strategic Total Return Fund to about 3.25 years. While this effectively realizes a moderate loss on bonds we purchased several weeks ago, part of those proceeds were shifted into TIPS which have shorter durations but have, in fact, suffered equal or worse losses in recent weeks. So it does not follow that the change in duration reduces our potential for subsequent gains. To the contrary, I believe that the best thing we can do at any given time is to align our investment position with the Market Climate that we observe at any particular time. Securities do not remember the price we paid for them, and we do not invest as if they ought to.
In the management of the Hussman Funds, one of the restrictions I use to guide my actions is that the Funds must always be aligned with the prevailing Market Climate. I do, however, allow a certain range of discretion in the exact percentage exposure or portfolio duration I choose, as well as in the specific securities I select to achieve that allocation. Both our Market Climate indications, as well as the discretion that I have taken around them, have generally added value. Last month, based on uncertainties regarding Fed tightening and currency markets, I chose more conservative exposures to bonds and precious metals than the Market Climate in these assets would have indicated on a purely data-driven basis. That decision helped to mute, but not avoid a decline in the Strategic Total Return Fund. The pullback would have otherwise been closer to 10%, representing one of the worst monthly drawdowns in our total return approach, based on historical tests.
The reason last month was so hostile for a diversified bond market strategy is that every bond-related asset declined substantially – Treasuries, TIPS, precious metals, utilities, and foreign government bonds. Usually, the correlation between these assets is much lower. For example, on a 100 basis point change in Treasury yields, TIPS yields generally move an average of 48-67 basis points. Last month, they moved one-for-one, meaning that the entire increase in interest rates represented an increase in real rates, not inflation expectations. Likewise, the correlation between bonds and the dollar is generally quite weak. Last month, the correlation was strongly negative, so that rallies in the dollar were accompanied by weakness in both bonds and precious metals. The stock market also shifted Climate, which meant that utilities lost ground not only because of interest sensitivity but also because of stock beta. None of this is to downplay the nearly 6% pullback in the Strategic Total Return Fund. But I do want to strongly emphasize that last month was one of the largest outliers we've seen in historical data, and that a somewhat conservative tilt in the portfolio was helpful in containing the impact.
One of the reasons that real interest rates have been rising (while gold and foreign currencies have been weak) is that investors seem convinced that the U.S. economy is breaking out into a period of robust growth, and if anything, foreign growth is cooling off. Last week, some fuel was thrown on that fire by reports that China was concerned enough about rapid growth to warrant a tightening of monetary policy. The dollar rallied and gold fell on the news, in the belief that slowing foreign growth would only make the U.S. that much stronger by comparison.
In my view, the market has the whole China thesis wrong. Economic growth in China has been extremely rapid, to the point where the Chinese government is quite concerned about “hot money” investments and profligate bank lending. As a result, we can expect China to tighten its grip on monetary policy. The implication for the markets, however, is profoundly different from last week's interpretation.
If China tightens monetary policy (and given its strong central control, it has much more effective tools to do this than the Fed), it must also allow interest rates to rise domestically. Yet that sort of tightening is completely at odds with a policy of holding down the value of the yuan, which is already under heavy pressure to revalue. As a result, we are probably very close to the time when China will finally, and possibly abruptly, allow a revaluation of its currency. The result would not be a strengthening of the U.S. dollar, but a weakening. Nominal yields, not real ones, would be pressured higher in the U.S., because rapid accumulation of Treasury securities has been the mechanism by which the Chinese have suppressed their currency valuations and supported the dollar. Meanwhile, the rapid inflow of capital to the U.S. would be cut short, resulting in much greater weakness in gross domestic investment than the markets seem to envision.
Overall, the implications of a Chinese monetary tightening and a yuan revaluation are stagflationary for the U.S. – an increase in inflation pressures coupled with a substantial shortfall in the foreign financing of U.S. gross domestic investment. For more comments on the potential for disruption this could have on the U.S. economy (somewhat theoretical a year ago and now fairly timely), see Freight Trains and Steep Curves.As I noted before, our particular investment exposures are informed by the particular Market Climates we observe, but I do have discretion as to the securities I select to achieve those exposures. At present, the Strategic Total Return Fund carries a 3.25 year duration (meaning that a 100 basis point move in interest rates would be expected to impact the Fund's value by about 3.25% on the basis of bond price fluctuations). All of this duration is held as Treasury Inflation Protected Securities. In addition, the Fund holds about 10% of its assets in precious metals shares. We continue to hold about 12% of assets in select utilities with yields high enough and durations low enough to appear attractive as part of a diversified portfolio. Aside from a small percentage in U.S. agency securities and foreign government notes, the remainder of the Fund's assets are presently in money market instruments.
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