May 17, 2004
Stocks are Not Thermometers
Stocks are not simply thermometers of current business conditions. They look forward, and they discount very, very long-term streams of future cash flows. Unless the entire stream of future cash flows is sensitively dependent on what happens over the near-term, the particular news of the day has very little impact on the fundamental value of a stock. The main factor that drives short-term movements is not news, or short-term growth, but the willingness of investors to take risk.
If you understand the idea of “present value,” you can prove to yourself that the price of a stock is strongly affected by small changes in the long-term rate of return demanded by investors, and not very sensitive to changes in near-term cash flows (unless those changes also affect the entire future stream). In most cases, news only matters because it makes investors a bit more or less willing to take risk.
The greatest danger to any market is when valuations are stretched, and investors suddenly become less willing to accept risk. At that point, very small increases in the risk premium demanded by investors can cause enormous declines in price. That's not a forecast, but it's a real danger here.
Two weeks ago, I noted that the market's response to news at any particular time is conditioned by the Market Climate in effect. Since then, we've seen many very “good” pieces of economic and corporate news, accompanied by clearly negative responses from investors. As CNBC's Joe Kernen remarked about technology on Friday, “no matter how positive the news was in these reports, the stocks did not react positively.”
The whole idea that stock market direction is tightly linked to near-term growth in the economy and earnings is contrary to both theory and evidence. Stocks are not simply thermometers of current business conditions (I've got this idea to have performing circus clowns bound across CNBC's set when analysts suggest that they are - it would be sort of a public service). Repeat this to yourself as you listen to bullish arguments. That isn't to say that no bullish argument has merit, but the ones that do will have to go further than a blind faith that the economy is revving up. Given that both valuations and market action are negative here, we are comfortable fully hedging the Strategic Growth Fund against the impact of overall market fluctuations.
Balance sheets matter
All of attention on earnings comparisons, GDP growth, ISM numbers and employment emphasizes income statements. But to a large extent, the sustainability of any income stream is dependent on the balance sheet – debt burdens, interest service, savings, and the availability of financing. The underlying assumption of investors is that the economy has been sufficiently “kick started” by tax cuts and monetary policy, so it will continue to grow along typical trajectories.
The problem with that assumption is that the economy never deleveraged itself during the recession. Normally, the U.S. current account moves to a surplus (meaning that domestic savings are more than enough to finance domestic investment without any need for foreign capital – an essential precondition for rapid growth in domestic investment during the subsequent expansion). Private savings rates also typically rise during a recession, and corporate balance sheets are deleveraged by paying down debt. None of this happened this time around.
[As a sidenote, a number of readers have asked whether money creation can somehow circumvent the economic identity that all investment must be financed by savings. The answer is no. It takes some careful accounting to see this, but suffice it to say that only output that is saved – not absorbed by consumption – is available for investment. It really is an accounting identity.]
With the massive U.S. current account deficit hitting fresh lows, there is little room to expand capital inflows from foreigners (a large contributor to past U.S. investment booms). Moreover, corporate balance sheets were improved not by debt reduction, but by swapping to short-term interest rate structures, so there is considerable yield curve risk to balance sheets. This also implies that unlike past experience, it is not at all clear that the next recession will require any sort of inversion in the yield curve – even a flattening could create sufficient strains on the economy. Oil prices have been rising as well, but unlike past spikes in oil, this one is accompanied by a significant spike in long-term futures prices. As the analysts at Bridgewater have noted, this implies that the market sees the increase in oil prices as structural, not just a temporary supply/demand imbalance. Finally, unlike other expansions (outside of the short-lived 1980 experience), indicators such as the ISM figures, new claims for unemployment and so on have been belied by a stubborn lack of improvement in capacity use and help wanted advertising (not even in the trend, which would occur regardless of internet advertising).
In short, the market is focusing on income trends without recognizing the importance of balance sheets, valuations, risk premiums, and the underlying demand for capital and labor. These factors will eventually get the attention they deserve, but unfortunately, many investors will have to learn to give them attention… a lot like someone would learn to attend to a swinging beam after getting whacked in the head a few times.
The Market Climate for stocks remains characterized by unusually unfavorable valuations and unfavorable market action. The Strategic Growth Fund remains fully invested in a widely diversified portfolio of individual stocks, but we have fully hedged those holdings against the impact of market fluctuations with an offsetting short position in the S&P 100 and Russell 2000 indices. Our main risk, as well as our primary source of returns here, is the potential for our stocks to perform differently than those indices. We do not move to cash in unfavorable Climates, because this “active risk” is typically an important source of long-term return for us. The Strategic Growth Fund was fully hedged through most of the period from July 2000 through March 2003. We did not observe any reason to avoid “active risk” then or now. In any market environment, some risks are more attractive than others. It's market risk that we want to neutralize here, not all risk.In bonds, the Market Climate remains characterized by moderately favorable valuations but unfavorable market action. The Strategic Total Return Fund does not hold any long-term nominal bonds here, but does carry a 3.25 year duration in Treasury Inflation Protected Securities. In addition, we continue to view the U.S. dollar as vulnerable, while the Market Climate for precious metals is clearly (though not aggressively) favorable. For that reason, we continue to hold about 10% of the Fund in precious metals shares, with an additional 6% position in select utility shares. These positions are aligned with the prevailing Market Climates in the corresponding assets, though our precious metals exposure is somewhat conservative due to the high recent correlation between bonds and the U.S. dollar. My personal view is that the strong, non-inflationary growth scenario has been overplayed, and that nominal bonds and the dollar are more vulnerable than TIPS or commodities. In its current position (which may change if various Market Climates shift) the Fund will tend to benefit most from any easing in the U.S. dollar or real interest rates.
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