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November 22, 2004

Canaries in the Coalmine

John P. Hussman, Ph.D.
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Just a note – the Strategic Growth Fund paid its annual capital gains distribution on Friday, in the amount of $0.705 per share, classified as $0.51 in short-term and $0.195 in long-term gains. The Strategic Total Return Fund paid a distribution of $0.022 per share classified as long-term gains (For informational purposes, during the year ended November 18, 2004, the net asset value of the Strategic Growth Fund increased by $1.04 per share). Please see "Tax math" in the November 8 comment for further remarks on Fund distributions.

Shareholders in the Strategic Growth Fund who opt to reinvest Fund distributions acquired additional shares at Friday's NAV of 15.09. For example, a shareholder owning 100 shares of HSGFX on Thursday would now own just over 104.67 shares. That factor of about 1.0467 can be used to compare current NAVs with past ones. For example, Friday's NAV represents a “pre-distribution” NAV of [15.09 x 1.0467 = ] just over 15.79.

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With the S&P 500 price/peak earnings multiple now above the levels registered at the 1929, 1972 and 1987 peaks, stocks have moved back into the “bubble” area seen only briefly during the period leading up to the market's 2000 peak. The combination of overvalued, overbought, overbullish, and overleveraged conditions doesn't strike me as a particularly sturdy environment to support further gains. Still, stocks continue to have one remaining support: investors are displaying a continuing willingness to bear risk, which we read out of the quality of market action.

Of course, risk preferences are a psychological factor, not a fundamental one. So there's little inherent in the “facts” – earnings, economic conditions, interest rates, and so forth – to add what Ben Graham called a “margin of safety,” or what Burton Malkiel called “firm foundations.”

Still, it's useless to fight reckless speculation, because you never know how far it will go. You can't stand in front of investors and say “No, you've become quite insane, really, and now it's time to stop.” For that reason, until we observe a fresh negative shift in the quality of market action on our measures, we'll retain some exposure to further upside potential through the use of call options as part of an otherwise well-hedged position. Given the very low level of option premiums here as measured by the CBOE volatility index, this mode of accepting market risk suits us very well.

Canaries in the Coalmine

Keeping in mind the soundly unfavorable condition of fundamentals, it's particularly important to monitor market conditions for developments that might signal deterioration in investors' speculative preferences, or present fresh catalysts for trouble, such as recession or currency risks. Though not exhaustive, the following are a few items that deserve attention.

•  Overbought “technical” indicators. The market has enjoyed a rare “uncorrected” advance that is usually seen at the very beginning of bull markets from very depressed valuations, or at mature points in a bull market characterized by “speculative blowoffs.” It's not difficult to guess which is probably occurring. The difficulty is that these blowoffs need not be singletons – a market peak can contain more than one. You can see the action most easily by looking at a point-and-figure chart, where the recent advance appears as a vertical “pole.” These poles can consolidate at higher levels, but can also break down vertically, producing a second pole in the reverse direction. Something to watch if you're looking for a reversal in market momentum. Others include the McClellan Oscillator (a measure of market breadth), which is also reversing from a severe overbought condition, and an odd little bird called Coppock indicator (a 10-month exponential MA of the average of the 11 and 14 month return on the S&P 500) – it peaked in June. An old Ned Davis rule is that a 6 point drop in the Coppock in less than 4 months is a danger signal – close, but not yet.

•  Valuations – A market at over 21 times record earnings doesn't have much of a safety net. Suffice it to say that when S&P 500 earnings have been at a record, the price/earnings ratio on the S&P 500 has historically averaged just 12. Even providing for further earnings growth to the peak of the long-term earnings channel that has contained S&P 500 earnings for the past century, even a P/E of 18 five years from now would result in annualized total returns of less than 5%.

•  The ISM Purchasing Managers Index. The Conference Board's index of leading economic indicators is now down for 5 consecutive months. Though the S&P 500 is no longer showing a negative 6-month return, other early recession warnings (widening credit spreads, a narrowing yield curve) remain in place. Flattening 6-month returns on the S&P 500 combined with a PMI below 50 would complete a 4-indicator recession warning that has occurred at or near the beginning of every post-war recession with no false signals. Again, not in place, but reasonably on the list of things to monitor.

•  Credit spreads – Though already widening modestly, any tendency for credit spreads to spike wider would be a signal of default problems ahead. The difference in yields between low and high rated debt is one of those indicators that tells you there's trouble ahead, even if it's more difficult to pinpoint exactly where it will emerge.

•  The U.S. dollar. On a short-term basis the dollar is probably oversold. Of course, bear markets can produce very sustained oversold conditions in currencies, as they do for stocks. Still, bear markets like to play a little game called “aneurism” with short sellers, by producing explosive rallies from time to time in order to clear those oversold conditions. Interestingly, the dollar is about fairly valued versus the Euro and the British Pound on the basis of joint interest rate and price parities (the basis of our currency valuation models – see Valuing Foreign Currencies). The problem is that with an enormous current account deficit, there is great potential for the dollar to move far away from those “parity” values. With the Fed now tightening and the dollar beginning to weaken, the U.S. economy seems very close to playing out some very unpleasant adjustments (see Freight Trains and Steep Curves).

•  Investor Sentiment. Late bull markets generally produce a classic dispersion in sentiment between value investors and trend followers. We're already seeing this as a substantial increase in selling by corporate insiders (now at roughly 5 shares sold for every share purchased), even while investment advisory sentiment has moved back to bullish extremes.

•  Market Internals. This area includes market breadth (advances versus declines), leadership (be alert when new 52-week lows outpace 52-week highs within a week or two of a fresh new high in the Dow or S&P), trading volume (beware volume that becomes dull on advances and picks up on declines), index divergences (e.g. Dow theory), industry action (watch financials – especially those dependent on mortgage loans and consumer credit), and speculative stocks (Google and other internet stocks, initial public offerings, and small cap stocks, all which are taking on the marks of a blowoff).

•  Treasury bill – Eurodollar spreads. A Eurodollar is a U.S. dollar deposit held at a foreign bank. (A Eurocurrency, more generally, is a bank deposit denominated in a currency outside of its domicile, so for instance, a Yen deposit at a bank in Singapore would be a Eurocurrency deposit). In general, monetary crises of many varieties tend to trigger instability in the T-bill - Eurodollar spread, largely because ED deposits are free from normal regulatory structures such as reserve requirements, deposit insurance, capital controls, and so forth. Like credit spreads, the T-ED spread can often be a signal of oncoming trouble, even if it can't be precisely localized. At some point, the massive continuing capital flows that finance the U.S. current account deficit will slow or reverse. It's not certain what form adjustment that will take, but if the markets sense something abrupt, it will likely show in the behavior of various interest rate spreads.

Market Climate

As of last week, the Market Climate for stocks remained characterized by extremely unfavorable valuations and still favorable market action. In other words, the market lacked investment merit in the sense that it is priced to deliver unsatisfactory long-term returns, but it continued to display speculative merit in the sense that investors continue to exhibit some preference to take risk.

In our own approach, the response is straightforward: keep the portfolio largely hedged, particularly against substantial downside potential, but retain exposure to local and upward market fluctuations by holding a small position (less than 1% of assets) in call options. At present, I would estimate our exposure to local movements in the market to be about 20%, which would increase toward 40% on a substantial market advance from here, and would decline toward 0% on a substantial market decline (that “curvature” owing to the properties of call options). So the Strategic Growth Fund will have a certain amount of "local" sensitivity in the event that the market declines here, but I am attempting to manage that risk in a fairly tight range.

In bonds, the Market Climate remains characterized by modestly unfavorable valuations and modestly favorable market action. The Strategic Total Return Fund continues to carry a duration of about 2.5 years, primarily in inflation-protected Treasuries. The Fund's exposure to precious metals shares remains about 16%, and provides the bulk of the Fund's exposure to the impact of currency fluctuations.

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