June 7, 2004
The Cicada Dance
Well, the noise of the cicadas is finally settling down – that loud, pitched, whirring sound like the corrugated plastic tubes we used to swing around our heads as kids – a cacophony of rasping calls, beating wings, and the rattlesnake-like shaking of billions of tiny moroccas. For a few weeks now, part of the local entertainment has been the sight of quiet, respectable pedestrians on Ellicott City street corners, suddenly breaking into the cicada dance – a kind of animated hip hop routine – as the things made beelines toward the nearest vertical object, which happened to be them.
One of the interesting things about the cicadas is the complicated way the species survives. Depending on the type, they emerge every 13 or 17 years – both prime numbers – so that any regularly occurring predator on a shorter cycle will not be present with any consistency. And they come out in such numbers that it's impossible for predators to eat them all. In short, the cicadas survive because they have inherent defense mechanisms built into their existence.
The financial markets have their own species like that – the secular bear. Secular bears emerge at a point of extreme overvaluation and have historically survived about 17 years until the markets reach a point of durable undervaluation. Between those points is a series of “cyclical” bull and bear markets, with the characteristic that each successive bear market ends at a lower level of valuation in terms of price/earnings, price/book, price/revenue and other fundamental measures.
How does a secular bear market survive for 17 years, on average? In other words, what are the inherent defense mechanisms that keep it alive, and prevent everybody from just selling and moving the valuation cycle to a much quicker resolution? The answer is simple: enough bull moves to keep hope alive all the way down to the ultimate low. Each secular bear market is punctuated by a series of intervening (and usually very convincing) bull advances, just like each cyclical bear market is punctuated by occasional fast, furious and prone-to-failure advances that clear the “oversold” conditions that appear from time to time. Only by understanding that basic structure can an investor maintain, to use Galbraith's phrase, “a durable sense of doom.”
Not that a sense of doom is the preferable state of things. But when investors start to believe that stock valuations can maintain, to use Fisher's phrase, “a permanently high plateau,” perhaps some contrary thinking is healthy.
Some basic math and a few critical results
Warren Buffett has noted that one certainty of the financial markets is that stocks will move between extreme overvaluation and extreme undervaluation, but that the transition between those points is not predictable. Still, for a long-term investor, knowing that values will fluctuate is enough to justify a varying exposure to market risk, and Buffett occasionally finds himself awash in cash for this reason. See, guys like Buffett recognize something that die-hard buy and hold investors sometimes miss: the long-term growth rate of fundamentals just doesn't fluctuate all that much for the market as a whole. Indeed, the peak-to-peak growth rate of S&P 500 earnings across market cycles has been remarkably consistent at about 6% annually regardless of whether one looks at the past 10, 20, 50 or 100 years.
So starting at 21 times peak earnings and a growth rate of 6% (feel free to use a historically unprecedented long-term growth rate like 8% to convince yourself how little small changes matter here), suppose we have confidence only that stocks will simply touch the historical median of 11 times peak earnings at some point in the future (the1990 bear ended at 11 times peak earnings, the average historical bear low occurred below 9 times peak earnings, and generational lows like 1974 and 1982 occurred at less than 7 times peak earnings). Given those assumptions, it hardly matters to a long-term investor when that occurs: 11 times peak earnings a decade from now would result in a total return of roughly [(1.06)*(11/21)^(1/10)+.5*(1 + 21/11)(.017)-1] = 1.84% annually. If it happens 20 years from now, the total return on stocks between now and then will be about 5.10% annually. Even if stocks take 30 years to simply touch historical median valuations, the total return on stocks between now and then will be about 6.21% annually. All of which explains why valuation arguments based on present year-over-year inflation rates or 10-year Treasury yields are so painfully vapid.
Even if we assume that stock valuations simply touch their historical average price/peak earnings multiple of 14 at some point in the future, the corresponding annual total returns on stocks over 10, 20 and 30 year horizons would be about 3.72%, 5.80%, and 6.51% respectively, depending on when that contact occurs. I won't even mention what would result from a decline to the kind of valuations we've typically seen at durable secular lows.
[Geeks note: the calculation here is [(1+g)(pf/pc)^(1/t)+.5*(1+pc/pf)*d-1], where g is the growth rate of fundamentals, pf is the future price/fundamental ratio, pc is the current price/fundamental ratio, t is time in years, and d is the dividend yield in decimal form. The first term gives annual capital gain factor, while the second term is the average dividend yield over the holding period. You subtract 1 to obtain the net return.]
So the question becomes, where are we in the cycle? Well, except for investors with no knowledge of how valuation levels translate into prospective returns, it's fairly clear that the 2000 peak represented the peak of a very, very aggressive secular bull move. At a current price/peak earnings multiple of 21, the S&P 500 is even now priced at about the same valuation as we saw at the beginning of very extended flat periods for stocks (notably 1929 and 1965, as well as important peaks like 1972 and 1987). That doesn't say much about short-term returns, and of course, it's precisely the potential for short-term returns that encourages even value-minded investors to hold on tight. Still, with our measures of market action now negative, even that speculative merit appears to be lacking.
If you look closely at a weekly or monthly chart of the S&P 500 extending a decade or more, it's evident that the market advance that we've seen over the past year-and-a-half has done a good job in “clearing” the cyclical oversold condition of the 2000-2002 bear. If a secular bear is indeed alive, this advance has had the function of prolonging its survival. The issue at this point is whether stock market risk is worth taking in an environment where both investment merit (favorable valuations) and speculative merit (favorable market action) are lacking. At present, in my view, it is not.
The Market Climate in stocks remains characterized by unusually unfavorable valuations and unfavorable market action. As usual, that's not a forecast, and it's important to keep in mind that we align ourselves with the prevailing Market Climate rather than make any attempt at prediction. If, for example, market action was to display broadly positive developments in a wide range of industry groups (always more an issue of quality than of extent or duration), our measures of market action could shift back to a favorable condition, and we would lift a portion of our hedges. I don't really anticipate that, but we never rule out shifts in the Market Climate, and it's that refusal to rule shifts out that prevents us from making even short-term “directional” forecasts about the market. For now, the Strategic Growth Fund remains fully hedged against the impact of market fluctuations, and the main factor driving our day-to-day returns is currently the difference in performance between the portfolio of stocks we own and the major indices. Money magazine's Jonah Freedman wrote a nice article for the May issue that discusses our hedging approach.
In bonds, the Market Climate is characterized by neutral valuations and modestly unfavorable market action, holding the Strategic Total Return Fund to a duration of about 3.25 years, mostly in Treasury Inflation Protected Securities. As we measure it, the Market Climate in precious metals continues to be favorable, though it would become particularly aggressive on signs of economic deterioration, which are not in place here. While the employment report was good enough to hold the unemployment rate unchanged, it was certainly nothing extraordinary from an economic perspective, except in the context of the past couple of years. Based on the current labor force, job creation of 235,000 per month would be right at the historical average. Since that historical average includes recessions, it's still a fairly tepid rate for an economic expansion.
Overall, the Strategic Total Return Fund would benefit most from dollar weakness and declines in real interest rates, with little sensitivity to changes in inflation. On a day-to-day basis, most of the short-term fluctuation in the Fund both up and down will tend to be driven by our precious metals shares, which represent about 12% of net assets here.
---With deep respect for President Reagan, who understood the legitimate meaning of peace through strength, and recognized the evil in some political systems without overlooking the hope and humanity of the people under them – even of their leaders. He was unflaggingly optimistic about human nature, and whether a particular policy affected rich or poor, he understood the difference between incentives and handouts in a way that neither Democrats nor fellow Republicans have since. Ronald Reagan was one of my few heroes, and the reason I've spent most of my life as a “conservative.” In many ways his views about humanity were closer to Jimmy Carter's than to the current Administration, which suffers by comparison from principles to nearly every aspect of policy. We are all poorer that he was unable to share more of that wisdom. Nancy Reagan called these last years “a very long goodbye.” His strong character and cheerful smile will be missed.
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