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July 19, 2004

How To Sail

John P. Hussman, Ph.D.
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“The most important thing you must know is the direction from which the wind is blowing. Program someone to ask you, every 2 minutes "where is the wind coming from?" You must point to it instantly, and be right. Put a wind vane at the top of the mast, and keep your eye on it. If you don't know wind direction, you will look sort of stupid when trying to use the wind as your engine. There are clues everywhere; flags, smoke, dust, moving clouds, ripples on the water, other sailboats, and blowing debris.”

- Roger MacGregor

Investing is a lot like sailing – you can go anywhere you wish without forecasting the wind. What is essential is to measure the wind properly and often, and align yourself with prevailing conditions.

That's not a suitable perspective for investors who want the certainty of knowing where the market is headed over the coming quarter or year (the subject of tireless discussion on the financial channels). But that's a certainty that can never be attained, and would turn thinking, breathing, active investors into dull spectators anyway. Life is in the living – the day to day uncertainty is part of the adventure.

Sure, you have to measure the wind often, and you need reliable tools to do that. Those tools have to involve more than just occasionally watching for a big wave. It's the little clues that matter – “flags, smoke, dust, moving clouds, ripples on the water, other sailboats, and blowing debris.” You don't wait for a large or sustained gust to “prove” that the wind has a certain direction. Instead, you look at the evidence from a wide range of measures, even ones that seem insignificant, focusing on whether anything seems out of place.

The anchor of valuations

From a valuation perspective, stocks are priced to deliver very unsatisfactory returns over a period of perhaps a decade or more.

I'll agree that if valuations (P/E ratios, price/book, price/sales, price/cash flow, dividend yields, etc) remain at current levels forever, stocks are priced to deliver between about 7.5% to 8% over the long-term. But even here, there are two problems. First, the argument that stock valuations are “justified” by current inflation and interest rate levels is not tenable from the standpoint of historical data. Second, even if it were tenable, the argument for permanently high valuations would rely on permanently low interest rates and inflation – not just for a few years, but forever. It bears repeating that so long as S&P 500 earnings remain in the same 6% peak-to-peak growth channel that has contained them for the past century, even if the price/peak-earnings multiple was to touch its historical mean of 14 a full two decades from today's level of 21 (the historical median is 11 which we saw as recently as the 1990 low, and most historical bear market lows have been closer to 9), the total return on the S&P 500 over that full period would be just 6% annually.*

Given that earnings growth has tracked nominal GDP growth over the long run, and that increased GDP growth of just a fraction of a percent is what economists consider a “productivity boom,” it's very difficult to plausibly get around the current valuation problem by assuming faster long-term earnings growth (unless it's due to inflation, in which case, the point is largely moot anyway).

Just like an anchored boat can move about the surface of the water if the chain is sufficiently long, an overvalued market may be constrained, but need not move in one direction only. Valuation says very little about near-term returns. Short-term returns are always driven more by whether or not investors have a preference to accept risk. Overvalued markets with skittish investors have historically been very dangerous. Overvalued markets with willing or risk-seeking investors have historically been reasonably rewarding despite the poor long-term implications for returns. On our measures, investors abandoned their robust preference to take risk in April of this year, making market risk unattractive on the basis of the average return/risk we've seen for the market in this Climate.

Still, recognizing danger is something different than forecasting a bad outcome. An open quart of gasoline next to the barbecue is a recognizable danger, but need not resolve into any particular outcome. It's just that the outcome isn't good on average. Similarly, the prevailing Market Climate is not a forecast that stocks must decline, because risk preferences can change at any time. It's only a statement that stocks have not performed well in this Climate on average.

Watching for a second wind

Among the factors that deserve attention, bearish sentiment is very thin right now, and we've seen a series of weeks with fewer than 20% of investment advisors negative, according to Investor's Intelligence. That isn't always an immediate negative for the market – low bearishness can also emerge, correctly, early in bull market advances with no ill effects. The danger is low bearishness that occurs when an advance is long in the tooth. That's what we seem to be observing here, and current bearishness is among the lowest we've seen since mid-1987. In terms of market action, the advances we've seen have been accompanied by deteriorating leadership and trading volume, so even improvements have a somewhat tenuous quality to them. Low volume markets also make it very difficult to gain traction from stock selection since dull volume is partly a signal that investors are unwilling to commit to any particular “theme.”

On the other hand, market breadth has been fairly resilient, and the negative shift we saw in market action during the second quarter has not seen much follow-through.

In short, market action appears very hesitant. As Richard Russell ( www.dowtheoryletters.com ) has noted, stocks have moved in a narrow, extended range of balanced accumulation and distribution for a few months now. Dow Theory calls this a “line.” From that long period of hesitation, it's obvious that investors have been on the fence. Lines don't last forever, and while I wouldn't trust a break one way or another as a clear “signal” or directional call, a shift in investor behavior – either positive or negative – would carry some importance. A greater level of commitment should also be accompanied by more active trading volume. In any event, we're carefully watching for any evidence – flags, smoke, dust… - that might suggest a second wind on the part of investors.

As for direction, there's no need for forecasts. There's no chance that we would move to a substantially unhedged position given current valuations and economic conditions, but an improvement in market action – especially on expanding volume – would prompt us to take a somewhat more constructive stance. In any event, there's no need to make forecasts. If and when the evidence shifts, so will the tack of our sails.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and modestly unfavorable market action. The Strategic Growth Fund held to a fully invested position in a broadly diversified portfolio of individual stocks, with an offsetting short position in the S&P 100 and Russell 2000 indices in order to remove the impact of market fluctuations from the portfolio.

In bonds, the Market Climate remains characterized by modestly unfavorable valuations and unfavorable market action, holding the Strategic Total Return Fund to a 3.25 year duration (meaning that a 100 basis point move in interest rates would be expected to impact the Fund by about 3.25% on account of bond price fluctuations). Nearly all of this duration is in TIPS, and we continue to hold about 14% of net assets in precious metals shares. The Fund remains positioned to benefit primarily from weakness in real interest rates and the U.S. dollar, with little expected sensitivity to inflation-induced shifts in interest rates.

* Annual long term return over T years = (1+g)(EPE/SPE)^(1/T) + DY(SPE/EPE+1)/2 -1

e.g 1982-2000: (1.06)(33/8)^(1/18) + .06(8/33+1)/2 - 1 = 1.1468 + .0373 - 1 = 18.41% annualized

EPE is ending price/peak earnings
SPE is starting price/peak earnings
T is the time horizon in years
g is the growth rate of earnings, peak-to-peak (historically within a very well defined 6% channel, regardless of whether you look at the past 10, 20, 50 and 100 years). So g = .06, but you can change that as long as you recognize that earnings and nominal GDP growth are very close over the long run, and that even a fraction of 1% in additional long-term GDP growth is called a "productivity boom" by economists.
DY is the initial dividend yield (the second term basically computes the average yield over the holding period).


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