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December 27, 2004

Risk Management is Generous

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

With the S&P 500 just over 1200, the price/peak earnings multiple on the index has returned to 21. Aside from the 2000 bubble peak, this multiple exceeds the valuation seen at any historical market peak including 1929, 1972 and 1987. Meanwhile, junk bond yields have been compressed to the point where the bond market is pricing in negligible probability of corporate defaults in the years ahead. Corporate BBB yields are just a half percent over AAA yields, while spreads on pure junk are only about 2% over comparable Treasuries. This will end badly.

After several years of minuscule Treasury bill yields and with the S&P 500 still below its level of 6 years ago, investors are frantic for yield and return - a context which makes even unimportant performance differentials seem devastating. We've seen this appetite for risk before, at the 2000 peak, and at numerous market extremes of the past. Of course, there is no assurance the market is at the peak of this advance, or that valuations will normalize quickly – certainly nothing that would prove useful as a short-term forecast. But risk management is generous - it is very tolerant of positions established somewhat early. Speculation, on the other hand, is extraordinarily unforgiving of positions taken off somewhat late.

Once again, investors seem to have lost their sense of simple algebra. It helps to remember that corporate earnings, despite extreme cyclical variability, are actually very well-behaved over the long-term. Whether one looks at the past 10, 20, 50 or 100 years, S&P 500 earnings have remained well contained in a 6% growth channel connecting earnings peaks across market cycles. Yes, earnings growth can be very rapid from trough to peak, with growth rates often exceeding 20% and 30% annually. But peak-to-peak variation is quite small. The growth rate of S&P 500 earnings was 6% from peak-to-peak even in the roaring 90's, productivity boom, new economy and all.

With regard to the S&P 500, the average multiple of price to peak-earnings has been just over 14, while the historical median is closer to 11. The 2002 market low occurred at a still-high 16 times peak earnings, while the median of 11 was last seen at the market's 1990 low. Multiples of about 7 attended the 1974 and 1982 market troughs.

Which brings us to the current price/peak-earnings multiple of 21. I certainly would not advise the following fact as an investment approach, but it turns out that an investor who did nothing more than sell the S&P 500 at a price/peak-earnings multiple of 19 and wait – often several years – to repurchase stocks at a multiple of 15, would have outperformed the S&P 500 with less risk over the past 20, 40, 60, 80 and 100 years. Indeed, over most of the past century, investors could have held Treasury bills, refusing to re-enter the market until the S&P 500 reached a multiple below 8, even if it took as long as 16 years to get there, and still they would have outperformed a buy-and-hold over the long-term. Again, I don't promote this approach – it has far too much tracking risk, makes no allowance for market action, requires an impossible amount of patience, and relies much too heavily on a return to specific valuations in the future. But it does underscore an essential point: risk management is generous. There is absolutely no evidence in the historical record that long-term returns are penalized by adopting a defensive market stance at very high valuations.

Let me say that again. Avoiding market risk at high valuations has never penalized long-term returns. The reason is simple. In terms of annualized returns, contractions in price/earnings multiples are extremely costly. At 6% peak-to-peak earnings growth, it takes four years of sideways price action to move the price/peak-earnings multiple from 19 to 15.

Not to mention a starting multiple of 21. Let's even be optimistic and assume (against all historical evidence) that earnings and dividends will grow at an 8% annual rate from their already record levels. Given the current 1.7% dividend yield, a still-elevated price/peak earnings ratio of 18, achieved 5 years from now, would be associated with annual total returns of just [(1.08)(18/21)^(1/5)+.017(21/18+1)/2 = ] 6.56%. That's a disappointing result to squeeze out of such positive assumptions.

More along the lines of historical experience, suppose earnings continue to grow at a 6% peak-to-peak rate, and in 7 years, the price/peak earnings multiple simply touches its historical average of 14 (never mind the historical median of 11 or major lows near 7 or below). Given those pedestrian assumptions, the annual total return on the S&P over the coming 7 years would average [(1.06)(14/21)^(1/7)+.017(21/14+1)/2 = ] 2.16%.

In short, one need not make catastrophic bearish assumptions to conclude that risk management poses little probable cost here. Optimistic assumptions are enough to produce pessimistic results. Ain't that a kick in the head.

Full cycles

It's useful to remember that long-term returns represent not only trough-to-peak advances, but peak-to-trough resolutions as well. Since 1940, the average bull market has run about 3.75 years in duration, and has produced annualized returns of about 25.2%. That sort of trough-to-peak return, far in excess of earnings growth, is what gives rise to subsequent bear markets, averaging about 1.25 years in duration, and taking stocks down at a –24.0% annualized rate. Overall return over a 5-year cycle: about 10.5% annualized. There's too much variation in those figures to rely on them as any guide to a particular cycle. Still, suffice it to note that buy-and-hold investors don't get the trough-to-peak return. They get the full cycle return.

Importantly, those past cycles started at valuations averaging less than 11 times peak earnings, and none (except for the recent run) began at valuations above 15 times peak earnings. Not surprisingly, the higher the valuation at the bull market peak, the longer the subsequent period of disappointing returns, in several instances extending more than a decade, though not without intermittent failure-prone bull market rallies to add excitement. This is what I often call “going nowhere in an interesting way.”

Again, nothing in these remarks speaks to short-term returns. I have no idea how to usefully forecast these. As long as we retain a measurable amount speculative merit as evidenced by market action, we'll accept a limited amount of market risk (primarily by hedging part of our market risk with put options only, rather than full index short sales against our stock holdings), but we're now in an environment where significant exposure to market risk is not an option for us. This is not a safe set of market conditions, historically, and neither a post-election rally nor a year ending in “5” will make it so.

As I hope I've emphasized in our prospectus and elsewhere, the Strategic Growth Fund is not a suitable asset for investors who wish to closely track fluctuations in the major indices. The Fund is an investment for which the full cycle matters, and for which peak-to-trough or trough-to-peak comparisons with the market are unrepresentative. Having informed shareholders is essential to me, which is why I write these weekly remarks. But we have no marketing department, and we don't pursue investors for whom our approach is unsuitable.

What matters deeply to me is providing disciplined management for suitable shareholders, with strong long-term performance as measured by annualized and risk-adjusted returns. Though I would expect to participate much more in bull markets which begin at reasonable valuations than ones that begin at elevated ones (as the current one did), I believe that our overall results since inception have been as intended – neither extraordinary nor disappointing relative to my expectations. I do believe that our discipline serves us well, and despite short-term uncertainties, that risk management is generous in the long-term.

Market Climate

Little change in the Market Climates for stocks and bonds last week. In stocks, the Climate continues to be characterized by extremely unfavorable valuations and still moderately favorable market action – though at present conditions are very overbought, so speculative merit is an increasingly risky basis for accepting market exposure. In bonds, the Market Climate remains characterized by modestly unfavorable valuations and modestly favorable market action, holding the Strategic Total Return Fund to a relatively muted 2.5 year duration, mostly in TIPS, with continued allocation of about 16% of assets to precious metals shares.


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