August 16, 2004
Mind the Gap
Straight to the Market Climate this week. The Climate for stocks remains characterized by unusually unfavorable valuations and market action so tenuous that it is statistically indistinguishable from an unfavorable condition. Our puts are sufficiently in-the-money that the Strategic Growth Fund is best understood as being fully hedged, with a small contingent exposure (less than 1% of assets) in call options, strictly to allow for the possibility that a favorable status for market action might magically be saved. I have absolutely no attachment to a bearish or bullish outlook on the market, and I'll unrepentantly shift our investment position if the evidence changes. But at present, we're fully hedged because valuations are bad and the last remnants of the positive signs that developed a few weeks ago are rapidly failing.
“Local” basis risks aside, I remain very comfortable with the diversified portfolio of stocks we hold in Strategic Growth, given that we're hedged against broad market risks. Our stock holdings do lean toward a “value” orientation – not as defined by simplistic rules such as low P/E or low price/book (stocks that are generally better classified as “slow growth”), but instead on the basis of discounted free cash flow, which allows for both rapid and slow growth stocks provided they are appropriately priced. Our additional emphasis on favorable market action also helps to align us with stocks and groups that are under accumulation, which makes us less sensitive to periods in which “value” underperforms. In any event, the stocks that have been hardest hit since the market's April peak have been high P/E stocks, whereas stocks having low price/revenue ratios and high dividend yields have performed better.
Still, I always pay close attention to even modest declines, asking whether there is anything unique to the situation that might warrant further research. The idea is not to depart from our approach simply due to pullbacks – I just won't do that – but instead to develop and test potentially useful extensions to our approach over a full data set. The acid test I usually require is that anything developed in one sample of data must demonstrate an improvement in the return/risk profile of our approach over a separate, larger sample of historical data in at least two split periods. Nothing in the current environment – including oil price or yield curve considerations – has fostered any modification to our approach (the last modification of note was in 2001, which defined a “sub-climate” in which extended bear market advances frequently emerge).
I have, however, responded to the increased risk of the current Market Climate by reducing our portfolio holdings in stocks with high price/revenue ratios or economically sensitive revenues. Essentially, those are the companies most at risk in the event of softness in profit margins. If any “style shift” has been consistently useful in responding to overvalued markets that develop unfavorable market action, that's it. Avoiding tech stocks in late-2000 also fell into this class of transactions. Despite the belief that the recent decline is also related simply to technology, my impression is that the real factor behind this decline is an anticipation of soft profit margins that typically accompany decelerations in economic growth.
I can't say that I'm satisfied with the flat returns in Strategic Growth year-to-date (though the market has been weaker on far greater volatility), but I do expect pullbacks from time to time, and this one is by no means unusual. In any event, I'm very comfortable with our widely diversified and fully hedged portfolio in the Fund.
Mind the gap
In contrast, I am concerned for unhedged buy-and-hold investors, who risk having their hat handed to them. That's not a forecast, but a recognition that every major market crash, and the majority of minor ones, have emerged from the sort of conditions we see at present – unfavorable valuations and unfavorable market action.
My opinion is that the risk of a market crash shouldn't be ruled out.
If you've ever been on the Tube in London, you're probably familiar with the repeated warning "Mind the Gap" as the subway doors open and close, reminding passengers not to step off into the abyss between the train and the platform. One of the striking features of the current market is the tendency for stocks to gap down on disappointing news. For those unfamiliar with the term in technical analysis, a gap is when a stock fails to trade at any price observed during the previous day, so that a high-low-close chart will show an open gap between the bars. Look at recent charts for CSCO, AMD, ANF and HPQ and you'll see the sort of action I'm describing. In a hostile Market Climate, gaps can be a lot like the start of a hailstorm. You see one hit, then another a bit later, and suddenly the sky opens up. I don't like this action at all, because it is a sign of illiquidity, and particularly skittish risk preferences.
Major stock indices and equity funds are showing losses of 5-12% year to date, and much deeper losses from their April highs. Stocks have also been very range-bound, on low volume, and it has been very difficult for any investment theme – value, growth, tech, large cap, small cap, cyclical, stable, etc – to gain traction. The disappointing action of stocks is at odds with investors' perceptions that the economy is expanding (which I have long asserted is an artifact of Q3 2003 tax refunds and the peak of the refinancing boom propagating itself through a few quarters of activity). I suspect that investors are becoming very frustrated, and are taking that frustration out on individual stocks that show even small disappointments. This isn't good. A market free-fall is always the combination of illiquidity and increasing risk premiums from very thin levels. That seems like the combination we have today. Again, that's NOT a forecast. But if your investment position and financial security relies on the avoidance of a market crash, you're taking risks that I wouldn't advise.
One short-term consideration is that the market is clearly oversold here. In a favorable Market Climate, buying oversold dips is generally an excellent idea. The problem is that this strategy can fail tragically in unfavorable Climates, when oversold conditions are cleared at best by fast, furious and failure-prone rallies, and at worst by sideways action or further oversold conditions. Oddly, despite the recent decline, the CBOE volatility index remains remarkably complacent at less than 18%. Typically, strong market declines will push option premiums to volatilities of 30% and higher. Bearishness among investment advisors also remains very low. So sentiment indicators remain strangely chipper despite the decline. Unusual that they aren't providing any confirmation for the technical overbought/oversold indicators.
There's certainly no ruling out a powerful rally to clear the technically oversold condition of the market at present. Also, despite my personal opinions about investment risks at present, there is nothing to prevent stocks from recruiting favorable market action again. Given that this is an election year, there is additional potential for market-friendly policy surprises of one type or another. The issue for us is always the prevailing status of valuations and market action, and that status is currently unfavorable. We don't make forecasts – it's enough to align ourselves with the prevailing Market Climate at any given time. That's certainly not a strategy that proves correct in every instance (and unfortunately did not over the past few weeks, as the S&P 500 has lost nearly 2% since July 23rd, when some favorable evidence briefly emerged), but in general, our flexible approach to market exposure has served us very well. Our interest is in how the market behaves on average in a particular Climate. At present, that average behavior is enough to avoid exposure to broad market risk.
In bonds, the Market Climate is characterized by unfavorable valuations and unfavorable market action. The Strategic Total Return Fund is carrying a relatively short duration of just 2.3 years, nearly all in TIPS, along with a precious metals exposure of about 15%, which is the Fund's other primary exposure here. While the risk of economic softening might suggest greater exposure to bonds, the offsetting factor is inflation pressure, which I continue to expect both on the basis of oil price action and, less recognized, on the basis of upward pressure on monetary velocity as short-term interest rates increase. I continue to suspect that the best time to establish bond exposure will be following inflation surprises that flatten the yield curve by driving up short-rates. I do believe that the inflation we'll see will ultimately be a short- to medium-term phenomenon. Until investors build more of a premium for it into bonds, however, nominal bonds may remain somewhat vulnerable to inflation surprises here.
The economy still looks fragile (balance sheets matter)
On the economic front, capacity use remains stagnant at just 77.2%. In a normal economic expansion, this figure would have surged above 80% about a year ago. The help wanted advertising index is still stuck near its recession low of 38. Internet ads might have affected the level that we might expect from this index, but the trend should have turned strongly higher regardless. The only U.S. expansion that failed to produce powerful expansion in capacity use and help wanted advertising was the short-lived 1980 rebound, which saw the economy slip back into recession within a year.
Moreover, the current account deficit has deteriorated further, and there growing pressure on China to revalue the yuan. I suspect that we'll get an abrupt revaluation and possibly substantial dollar weakness in 2005, but this is something that I am paying close attention to even here. Over half of the float in U.S. Treasuries is now owned by foreigners, largely China and Japan, and this financing has been responsible for the ability of U.S. gross domestic investment to remain uncrowded by growing fiscal deficits. Ex-foreign capital inflows, the quantity of U.S. gross domestic investment financed by U.S. domestic savings has not grown since 1996, and U.S. debt levels relative to GDP are now well beyond their prior 1929 peak. It is accounting nonsense to expect strong, investment-led economic growth when so much of that investment is already dependent on the largest inflows of foreign capital in history, and the majority of those inflows are tied to a single objective – holding up the U.S. dollar relative to the Chinese yuan and Japanese yen.
China is also an important aspect of the current geopolitical situation. It seems amazing that the markets aren't wringing their hands at all over the potential for the U.S. to be drawn into an escalating conflict with China – over concerns that Taiwan's government might continue a push toward Constitutional changes and independence. China executed a military “exercise” last month, releasing about 18,000 troops in air, sea and ground attacks on an island resembling Taiwan in many respects, while the Chinese foreign minister demanded an end to U.S. military relations with (and arms supplies to) Taiwan. Talk about gunboat diplomacy - the U.S. responded with a huge, coordinated Naval readiness drill with seven carrier groups (insisting that the timing had nothing to do with the Chinese exercises). The U.S. faces an uncomfortable contradiction, featuring both a “one China” policy (publicly rejected by Taiwan's president) that Taiwan is a province of China and subject to future reunification, and a “Taiwan Relations Act” pledging to defend the country if it is attacked. The increasingly provocative situation there should not be overlooked.
In short, there are many features in the current market and economic picture that could end badly. Given the poor state of fundamentals, our recent exposures to market risk have been strictly due to speculative merit. While speculative merit should not be ruled out as a valid reason to take risk, I am frankly more comfortable when both valuations and market action tell the same story. Still, our investment stance will change if the evidence shifts. For now, we're defensively positioned in both stocks and bonds.
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