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April 25, 2005

The First Sale is Often the Best Sale

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

The Market Climate for stocks remains characterized by unusually unfavorable valuations and unfavorable market action. Last week, we observed a good example of the kind of “fast, furious, prone-to-failure” advance that often emerges to clear an oversold condition. Given the “shelf” of prior support at about 1160 on the S&P 500, it was fitting that Thursday's explosive rally took the index to 1159.95, before failing on Friday.

Again, this isn't a market where day-to-day fluctuations are likely to provide an enormous amount of information. The current Market Climate – jointly unfavorable valuations and market action – has historically been characterized by negative average returns, but also by relatively high volatility, resulting in a very poor return/risk tradeoff. That also means, by definition, that the range of possible short-term outcomes is likely to be very wide. An unfavorable Market Climate emphatically does not translate into predictable short-term market losses. The small “predictable” component of returns in this Climate – the average daily loss – represents only a few basis points a day. That's a figure that is utterly, absolutely and completely swamped by daily volatility. The same is true for weekly, monthly, and to some extent even quarterly changes. Again, the predictable component of returns, though negative on average in this Climate, is overwhelmed by the volatility.

Historically, the current set of characteristics has occurred less than one-quarter of the time, but has contained nearly every major market plunge of note, including 1929, much of the 1973-74 decline, 1987, and of course the most brutal portions of the 2000-2002 bear market, among many other less notable losses. It would be a mistake for investors to rule out the potential for bad things to happen here. As I noted last week, if a loss of say, 30% on your unhedged stock investments (index funds and the like) would cause unacceptable harm to your financial security, you're probably taking too much risk. It's common to think that it's too late to sell with the market already 6-8% below its highs. On that note, it's a useful reminder that the market was already 14% below its highs before the crashes of 1929 and 1987, which underscores the old saying that “in a bear market, the first sale is usually the best sale.”

Again, that's not a forecast, but be honest with yourself - if you're taking too much market risk, now is a good time to shift your investment position enough that you'll be able to sleep at night regardless of what happens next.

On the bright side, despite the potential for losses, this is also an environment that has historically been marked by high volatility. So a market advance can't be ruled out. What happens then? Fortunately, most sustainable market advances recruit favorable market action fairly quickly. I expect that if an advance does emerge with sufficiently firm internals (breadth, leadership, industry action, trading volume, etc), we would soon be able to conclude that the quality of market action had become favorable once again, and would be able to increase our market exposure on that basis.

For now, suffice it to say that we remain fully hedged, and view the market defensively. As for expectations about the short-term direction of the market, no additional forecasts are required.

In bonds, the Market Climate remains characterized by moderately unfavorable valuations and moderately unfavorable market action, holding the Strategic Total Return Fund to a duration of just under 2 years (a 100 basis point change in interest rates would be expected to impact the Fund by about 2% on the basis of bond price fluctuations). Based on an improvement in valuations and additional evidence regarding the combination of inflation and economic weakness, I slightly increased the Fund's exposure in precious metals shares from just under 16% to about 18%. I continue to view this moderate exposure to precious metals shares as an important component in our investment stance.

Is it different this time?

One of the new lines that I heard last week was that things are different now than they were historically, so we should all be quite bullish on the market and the economy. The main point was that the past two expansions (the 1980's and following a brief recession, the 1990's) were among the longest on record, so we can expect the current expansion to be similar, thanks to new technologies, a smarter Fed, and so on.

This is superstition at its best. Among the drivers of the 1980's and 1990's expansion, very apparent even at their beginning if one cared to look, was the clear emergence of new large-scale technologies – personal computers and biotech among them in the 1980's, networking, telecommunications and the internet in the 1990's. Both periods began with current account surpluses and enjoyed very broad investment booms driven by a declining share of government spending to GDP, rising levels of imported savings from foreigners, and a shift from real assets to financial assets prompted largely by a persistent trend of disinflation.

We've got none of it here. The current account is already at record deficits, government spending is expanding relative to GDP (which feeds inflationary pressures), and to the extent that investors are excited at all about any industry group, it's bubble-redux (valuing stocks like Google as if they are infinitely growing perpetuities despite the lack of meaningful barriers to entry). There is very little in the way of new large-scale technologies that would pace a capital spending boom – even if the savings to drive it were available. Quite the contrary, to reprint a chart that appeared in the February 14th comment, capital spending by S&P 500 companies has dropped to the point where it is barely replacing depreciation.

If certain congressmen get their wish, we'll also be imposing sanctions on China unless it revalues the yuan, which will only further reduce the availability of investable capital to the U.S. (has anybody noticed housing starts?).

In short, we've observed a number of periods of booming investment and growth-pacing technological innovation over the past century. This isn't one of them by a long-shot. If there is any extent to which the U.S. is in a new era, it is most probably that we are near the beginning of a “deleveraging cycle” where our over-dependence on consumer, business, government and foreign indebtedness will be resolved by much lower growth in gross domestic investment than in recent decades.

That said, imbalances like the current account deficit and low savings rates don't necessarily resolve into persistent short-term problems. Certainly, none of these comments should be taken as pointed negative short-term forecasts about the market or the economy. Rather, the uninspiring condition of market and economic fundamentals should be used to provide context for those short-term movements – despite occasionally strong short-term market performance or economic reports, nothing is likely to advance in a way that compromises long-term returns for conservative investors. In short, long-term investors can afford an additional emphasis on risk management here (for more on that view, see the December 27, 2004 comment ).


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