March 7, 2005
Triumph of Low Expectations
It is usually a danger sign when investors extrapolate good economic news by pricing stocks to reflect “new era” valuations. It's even worse for investors to accept “new era” stock valuations when the economic news just isn't that good to begin with.
Friday's employment report was greeted by ebullient commentary that the economy was “firing on all cylinders” and other such nonsense. The reality, however, is that job creation – even February's 262,000 jobs figure – continues to fall dramatically short of even mundane historical norms. The optimism over the February employment report represents little more than a triumph of low expectations over reality.
Since the 1960's, job creation during economic expansions has easily exceeded 0.2% of the labor force on a monthly basis (closer to 0.3% after the first 18 months of an expansion, when the labor market finally gets past the normal post-recession lag in job growth). In today's figures, that would translate into average job creation in excess of 400,000 new jobs per month at this point in an expansion (or any point after the first 18 months, for that matter). Even with the much vaunted expansion of the past year, job creation has averaged less than 200,000 per month - less than half the typical growth rate, and February's figure was so tepid that it didn't even absorb new entry into the labor force, leaving the unemployment rate two-tenths of a percent higher than January.
Meanwhile, investors seem not to recognize that the rapid expansion in corporate profits we've seen during the past two years represents nothing but a typical recovery toward the 6% growth line connecting earnings peaks for most of the past century (the earnings chart from the February 22 comment is reproduced below). While the S&P 500 is again trading at 20 times record earnings (that being a figure seen previously only at major peaks like 1929, 1972 and 1987), one might look at the fact that earnings have not quite reached that 6% long-term growth line, and take comfort in the fact that the S&P 500 is still under 19 times “attainable” earnings from that perspective.
Unfortunately, a multiple of nearly 19 is small comfort when one recognizes that, using those “attainable” earnings on the 6% growth line as a basis for P/E calculations, the S&P 500 has historically traded at just 10 times “attainable” earnings, on average (the median is about 10.5).
An additional problem here is that earnings are presently benefiting from profit margins that are very high in a historical context. To the extent that these profit margins are indefinitely sustainable, it would follow that corporate earnings should grow at about the same rate as nominal GDP in the coming years (6% growth being a somewhat optimistic bogey in the absence of more rapid inflation). More likely, however, profit margins will normalize in the coming years, as they typically have done historically (being among the more reliably mean-reverting economic series). That suggests that prospective earnings for the S&P 500 may fall substantially short of 6% annual growth in the coming years, which would make the current valuation multiples all the more unwarranted.
All of which makes it clear that investors really learned nothing from the 2000-2003 market decline. Though the advance of recent years has not erased the losses since the 2000 peak, and the S&P 500 is still below its level of 6 years ago, the memory of losses has faded enough for investors to once again take leave of their critical faculties. Suffice it to say that the historical record provides very few bases on which investors should expect the current market environment to end well.
As always, nothing in these comments should be taken to suggest that stocks should or must decline over the short-term. Rather, the increasingly defensive tone of these weekly remarks reflects the combination of untenably high valuations and gradual deterioration of market internals (despite continued resilience in the major averages). We're not yet at the point where both valuations and market action are unfavorable enough to justify a fully defensive stance toward market risk. But while we continue to carry a modestly positive exposure to market fluctuations, I am also increasingly convinced that further gains from here in the market will ultimately prove transitory.
If a further deterioration in market internals lies ahead, it would ideally develop in the face of continued strength in the major indices. That often happens during the later stages of bull market advances – breadth, leadership and market internals often weaken even before the major indices do, as investors gradually become more averse to risk. The combination of unfavorable valuations and market action then allows an informed shift to a fully hedged investment position while the major indices are still elevated. Unfortunately, there is not enough precedent to rely on the hope of a timely shift in the Market Climate – certainly not enough to keep a major portion of our investment capital at risk of market fluctuations. So we're already substantially hedged here. Modestly constructive, to be sure, but not enough that an abrupt decline in the market would be of much concern.
In the end, our objective is to achieve strong total returns and risk-adjusted returns over the full market cycle, with smaller periodic losses than a buy-and-hold approach on the major indices. Given current valuations and market conditions, a substantial exposure to market risk would be antithetical to that objective here.
As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and still modestly favorable market action. On a short-term basis, the market appears substantially overbought, which creates additional vulnerabilities.
Probably the two questions that I ask myself most frequently in the day-to-day management of the Funds are ones that come from Chess: “What is the opportunity?” and “What is threatened?” It's useful to remember that overvalued, overbought points in the market often represent very good times to review investment holdings with an eye to those that may be particularly threatened – especially those with substantial volatility that have enjoyed unusually strong recent advances. It's also a point where I typically take opportunities to change the strike prices and expirations of various option positions.
As I've frequently noted, the active management of our option positions (for example, raising strike prices after substantial advances and lowering them after substantial declines) can often offset some or all of the “time decay” of those investments. In general, it is beneficial to hold option premium when the actual volatility of the markets exceeds the implied volatility that is priced into call and put options. That's been the case recently, which continues to support the use of put options to partially hedge the stocks held in the Strategic Growth Fund. Overall, about 70% of the Fund's positions remain hedged using matched long put / short call combinations (which effectively act as interest bearing short sales in the S&P 100 and Russell 2000 indices), while the remaining 30% of the Fund's exposure is hedged with put options only, leaving the Fund with a modest positive exposure to market fluctuations overall.
In the Strategic Total Return Fund, I modestly increased the duration of the Fund's holdings during the recent selloff in bonds. As of last week, the Market Climate for bonds remained characterized by unfavorable valuations and moderately unfavorable market action, so the increase in duration was still limited, currently at about 2.8 years (meaning that a 100 basis point change in interest rates would be expected to impact the Fund by about 2.8% on the basis of bond price fluctuations). The Market Climate for precious metals remains uniformly positive, and the Fund accordingly holds just under 20% of assets in precious metals shares.
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