July 12, 2004
The Physics of Bounce
Mister Fantastic of the Fantastic Four owed his superhuman powers to his altered molecular structure (caused by exposure to cosmic rays, along with his crewmates Johnny Human Torch, Invisible Woman, and Thing). By one account, “after his body absorbs the kinetic energy of a ballistic projectile's impact, he can expel the object back along its trajectory by flexing like a trampoline if he is adequately braced.” Cool. The trick behind “bounce” is to convert kinetic energy to potential energy and back again.
Probably the easiest way to think about bounce is to look at a super-ball. Potential energy is energy that the ball has “inside” of it by virtue of its position (PE = mass x gravity x height). Kinetic energy is motion. Basically, a super-ball is good at switching between the two kinds of energy without losing a lot on impact (as heat). When it hits the ground, all of its energy is kinetic (since height = 0), but it absorbs the energy, returns to its original shape very quickly, and converts the energy back to potential as it flies higher. Super-balls also bounce around madly, because they conserve a lot of their spin too. A no-bounce ball, on the other hand, isn't very good at absorbing and converting energy, because it returns to its original shape too slowly, and loses a lot of energy to the ground as heat.
Financial markets are similar. Financial PE's are driven by substance, gravity, and sheer elevation. When the market plunges to earth, as it did from 2000 through early 2003, that potential energy of overvaluation gives way to kinetic energy of motion. Investors who ignored the potential energy of the market's overvaluation at the 2000 peak were vastly unprepared for what followed. Investors who understood value were unsurprised, particularly when “gravity” shifted and investors began to display risk-averse behavior in September 2000.
One of the difficulties in analyzing the markets from a valuation standpoint is that even if we observe a high potential for long-term weakness, it doesn't necessarily translate into the “kinetic” energy of short-term weakness. Despite the fact that value investors were ultimately vindicated, they were badly bruised during the “bubble” portion of the late 1990's advance. For that reason, it is important to realize that overvalued markets can become even more overvalued so long as investors have a robust willingness to take risk (which we read out of the quality of market action or lack thereof).
The market also bounces. What distinguishes a super-ball from a no-bounce ball is its ability to absorb the impact and return to its original shape. As long as investors, consumers and businesses are like Mister Fantastic and can bounce back – recovering their willingness to take risk – then even poor long-term fundamentals are not enough to make the overvaluation dissipate. Instead, you get a lot of bouncing - a long secular bear market instead of a single, deep, cyclical one. Yes, in the long-term, overvaluation implies that unsatisfactory returns are inherent in the super-ball, but over the short-term, the market can advance strongly if investors are still inclined to take risk. And of course, the ability of Wall Street analysts and market strategists to maintain their spin is legendary.
Even without forecasts, we know enough to decide how much risk to assume at each point in time. When valuations are elevated and market action is unsatisfactory (based on price and trading volume behavior across a wide range of stocks, industries, and security types), elevated super-balls have historically had difficulty making further upside progress (particularly sustainable progress), on average. In those instances, there is no conflict between the two objectives of achieving long-term returns and managing risk – both argue for a defensive stance. When at least one or both of those considerations are favorable, there has historically been at least some investment or speculative merit in accepting the impact of market fluctuations. Not here, at least at present.
It's important also to recognize that investors are generally served better by looking for stores of potential energy than by reacting to the kinetic energy of the day. Just like people should be aware of the pile of newspapers next to the stove, and the toddler teetering in her high-chair, investors should recognize the current elevation of stock market values, the enormous amount of debt and potential for deleveraging in the U.S. economy, the deep U.S. current account deficit and its potential to cause a drag on gross domestic investment for years to come, and the increasing pressure on China to abruptly revalue the yuan, thereby removing a major source of demand for U.S. debt issues. None of these necessarily resolve into short-term risks, but to ignore them because one cannot find a near-term “catalyst” is to rely on warning signals that may not arrive predictably. In short, there is a lot of potential energy to be recognized, monitored, and managed.
Looking back at the lows
To place current market conditions into perspective, it might be helpful to go back to the early phase of the market's advance from its lows. To a large extent, the advance we've seen over more than a year has been, if not predictable, at least well within what could have been expected. The following excerpt is from my April 2003 remarks:
“Still, with valuations still above normal, how far could an advance really be expected to go? My opinion is that it would be difficult for a market advance to run much beyond about 20 times prior peak earnings. Except for the most recent bubble, that level has historically put a cap on the market. Still, that's about 19% above current levels. In price terms, a 1/3 retracement of the S&P 500's peak-to-trough bear market loss would take the index to 1027, still 15% above current levels, and a fairly minimal target even within an ongoing bear market. A retracement of half the S&P 500's losses would take the index to 1152, about 29% above current levels. This figure would also be within historical precedent for past bear markets, but it would require the market to reach valuations that would be difficult to sustain. Suffice it to say that neither overvaluation nor poor economic fundamentals prevent the possibility of a substantial market advance. But again, we don't forecast, we identify. If the Market Climate becomes favorable, we remove a portion of our hedges. If it becomes unfavorable a week later, we put the hedges back on. No forecasting required.”
With the S&P 500 at 1112, the “bounce” that we've seen from the 2003 lows has been well in line with the sort of advances (even “echo bubbles”) that are typical off of bear market declines. Stocks are already priced to reflect more earnings growth than could plausibly sustain current valuations indefinitely. So in my view, the issue at present is whether or not investors' emerging skittishness toward risk will reverse or accelerate. There is no useful way to answer that in the form of a forecast, so as usual, our approach is to align our investment position with the Market Climate we observe at each particular point in time.
As of last week, the Market Climate in stocks was characterized by unusually unfavorable valuations and modestly unfavorable market action. This is sufficient to warrant a full hedge in the Strategic Growth Fund, in order to mute the impact of market fluctuations as much as possible. It's unclear, however, whether investors will get a “second wind” to speculate, or whether they will become increasingly skittish as earnings reports and geopolitical events unfold. As usual, our measurement of that is based much more on the quality of market action than on the extent or duration of any particular market movement, so it's possible that we could observe a shift in Market Climate without requiring an extensive or sustained market advance first. For now, however, we don't have the evidence to carry anything other than a fully hedged investment position in stocks.
In bonds, the Market Climate remained characterized by modestly unfavorable valuations and unfavorable market action. There are two distinct factors impinging on bonds here. The first is the likely acceleration of inflation as a result of increases in monetary velocity (velocity always jumps following increases in short-term interest rates, increasing the inflationary impact of the prior monetary ease). Though our relatively defensive stance in bonds (a 3.25 year duration primarily in TIPS) doesn't rely on forecasts, there is a good chance of positive inflation surprises ahead, and the risk of an abrupt revaluation of the Chinese yuan would add to that potential, and could also remove an important source of demand for near-term Treasuries, causing a more abrupt flattening of the yield curve (short yields rising) than is widely anticipated.
The second factor is the overhang of corporate debt, which creates the potential that defaults may become an issue as short-rates rise. This is something of a longer-term consideration, but could contribute to a safe-haven demand for Treasuries somewhat later in the cycle. An ebbing of economic momentum would also be supportive for long-term Treasuries, and my impression is that the current economic recovery is not as young or sustainable as the consensus appears to believe.
So in my opinion , the near-term and long-term prospects for Treasuries differ, as do the prospects for short-term and long-term maturities. I suspect that a flattening of the yield curve via a spike in short rates may very well coincide with an excellent opportunity to extend durations in long maturities (due both to default risks and eventual economic slowing). That said, our investment position is always driven by the Market Climate we observe at any particular time; not by forecasts, and not by any particular scenario. For now, we don't have enough evidence to move out of our relatively restrained 3.25 year duration in the Strategic Total Return Fund.In response to various questions about the merits of income funds, I recognize that the accepted logic is that bond yields must rise across the board and that bond-oriented funds must therefore be avoided. In my view, it is not at all clear that there is considerable risk at the long end of the yield curve (though again, we don't yet have enough evidence to establish much duration there yet). In the meantime, our modest duration in the Strategic Total Return Fund is dominated by TIPS, and the Fund also has roughly 13% of assets in precious metals shares, so the primary factors affecting the Fund at present are shifts in real, not nominal interest rates, and fluctuations in precious metals and the U.S. dollar. In any event, I'm fairly skeptical of consensus opinion as it applies to the bond market, and wince at the notion that such views can be usefully applied to funds with the ability to vary their duration and asset mix.
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