April 11, 2005
Bang a Gong
They don't ring a bell, but as of last week, the Market Climate for stocks has shifted to a clearly negative condition, characterized by unusually unfavorable valuations and now clearly unfavorable market action (I generally report these changes with a lag if there is anything material to execute, but the present shift should be no surprise).
Importantly, this shift should not be taken as a negative “point forecast” for upcoming returns, but as a change in the likely probability distribution of stock returns (see the March 14th comment for more on this distinction). It does not imply that stocks must or even should decline in this particular instance, but it does indicate that the present set of market conditions has historically been associated with poor average total returns. Based on conditions that we can actually observe, we have sufficient evidence about the likely return/risk profile of market returns to warrant a fully-hedged investment position. No specific forecasts required.
Keep in mind that our strategy isn't to forecast future market conditions, but to align our investment position with prevailing ones. I have absolutely no attachment to a favorable or unfavorable market outlook, and the current change in conditions should not be confused with a "call" on future market direction. It's not out of the question that the quality of market action could improve enough to signal a fresh willingness of investors to accept risk, and of course we would respond by establishing a greater exposure to market fluctuations on that evidence. But here and now, the quality of market action is not consistent with what we normally observe in a robust investment environment.
When the Strategic Growth Fund is fully hedged, its returns are driven by the difference in performance between the diversified portfolio of stocks owned by the Fund, and the returns on the indices we use to hedge (primarily the S&P 100 and Russell 2000 indices). This performance spread has accounted for much of the Fund's total return since inception, the remainder (as well as the Fund's muted volatility) being attributable to hedging and the selective exposure to market risk that the Fund has accepted from time to time. A fully hedged stance implies that the value of stocks held by the Fund is matched with an offsetting (interest bearing) short position in the major indices of approximately equal size, so that the “beta” of the Fund (the expected impact of market fluctuations on the value of the Fund) is shut down as much as possible. The dollar value of our shorts never materially exceeds our long holdings.
Whatever can go wrong …
In simplest terms, an unfavorable Market Climate means that stocks are richly priced, and investors have become skittish toward market risk, as evidenced by the quality of market action (or lack thereof).
Richard Russell of Dow Theory Letters once remarked that “in a bear market, whatever can go wrong will go wrong.” There's a lot of truth to that. As a practical matter, I don't really view stock price movements in terms of bull and bear markets – they don't exist in observable reality, only in hindsight. Still, the same sort of Murphy's Law holds true with respect to favorable versus unfavorable Market Climates (which, by construction, are identifiable in real time).
In general, the “spin” that investors most easily accept about a given news event is related to their predisposition to take risk. When investors abandon their willingness to accept increasing levels of market risk and instead begin to show signs of skittishness, no news is good news. For example, in a favorable Climate, rising interest rates are often taken as a favorable sign about economic growth and earnings, while in an unfavorable Climate, rising rates are taken as cause for alarm. Moreover, there seems to be a general tendency for economic surprises and earnings reports to come in on the negative side during unfavorable Market Climates. For this reason, I look at unfavorable market action as both a signal about investors' attitudes toward risk, and also about investors' information about future events. On the basis of what we can infer from current market action, we have to allow for the possibility of unfavorable developments here.
Apart from the broad deteriorations that have already occurred, the last straw for market action was that a number of key concerns for the market – interest rates, oil prices, the U.S. dollar – all improved, but broad market action failed to respond. Financials, bank stocks, corporate bonds and other interest-sensitives failed to improve in response to the rally in Treasuries, transportation stocks fell apart despite the pullback in oil prices, neither market breadth, leadership or other internals have exhibited strength, and so on.
Moreover, at this point, interest rates, oil and the dollar have all corrected their prior, extreme moves, which exhausts the benefits that their recovery from oversold (overbought) conditions were expected to provide. Given that these measures have been among the most important concerns for investors in recent months, the failure of stocks to respond to their improvement implies that there is more negative information than meets the eye. A clearer, but slightly improper way of saying this is “if stocks can't rally on lower rates, lower oil and a stronger dollar, what happens if they deteriorate again?”
Again, the shift to a low return, higher risk Market Climate doesn't necessarily imply that any particular return drawn from that Climate has to be negative. The Climate we've entered has historically experienced some periods of very strong returns (usually brief, unpredictable advances to clear oversold conditions). But on average, returns have been negative, and I would be remiss if I didn't note that nearly every major stock market plunge of note has emerged from the conditions we currently identify: elevated valuations, unfavorable market action, and rising interest rates.
Personally speaking, I wouldn't characterize my own views about the market as “bearish,” but rather as “defensive” – the major indices may or may not be profitable over any particular horizon here – a day, a week, a month, for example – but I don't believe that market returns are likely to be positive, on average. In my view, substantial market exposure doesn't seem worth the risk here.
In bonds, the Market Climate is characterized by unfavorable valuations and still unfavorable but modestly improving market action – mostly related to widening credit spreads and long-term yield behavior suggestive of oncoming economic weakness. We don't have enough evidence yet to anticipate that sort of weakness, and I think it's premature to establish much portfolio duration on that expectation. Still, we're reasonably at the point where it would be helpful to monitor market action and economic developments for early signs of economic trouble. For a list of useful indicators, see the section on recession risk in A Brief Economics Primer.
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