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May 9, 2005

A Fine Line

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

“There's a fine line between clever and stupid.”
- Spinal Tap

One of the difficult judgments in investing is to identify the point where market conditions change from favorable to unfavorable or vice versa. It's important to avoid the temptation to “overfit” the data – choosing magic thresholds and wildly complex rules by which to invest. To believe that the market will actually obey these carefully optimized rules in the future is a sure way of crossing the line between clever and stupid.

The difficulty, as the Buddha taught, is that the moment we force the world into some “mental formation” or concept we've created, we stop being open to truth.

For example, there's an old rule called “two tumbles and a jump” – historically, soon after the Fed cut interest rates two consecutive times, the market invariably responded with powerful gains over the following year. This rule seems to work well provided that the market is already reasonably valued and deflation is not a concern. Unfortunately, a number of analysts blew themselves up following this rule during the 2000-2002 bear market, as the Fed cut rates more than a dozen times even as the market continued to plunge. The proper approach, I think, was to look deeply enough into the situation to ask why “two tumbles” worked historically in the first place, and to recognize the potential for deflation fears, valuations, and credit risk to modify the outcome. The refusal to follow indicators blindly is the difference between analysis and superstition.

That doesn't mean that investors should go around with no principles at all, constantly saying “it's different this time.” It just means that you never accept any rule of investing as hard fact. For my part, I regularly ask whether I am missing something in the current market picture, and subject any potentially important factors to analysis. If something can be tested with historical data, helps to explain the current situation, and also improves the ability to explain historical market fluctuations in split samples, it's clearly worth watching.

For example, I used to believe that overvalued markets should go down. But there are many historical periods where overvalued markets simply became more overvalued. During the late 1990's bubble, many investors came to believe that “the old valuation measures don't matter anymore,” with devastating results. Looking at the data more closely, it turned out that studying the quality of market action not only helped to explain the bubble in progress, but also helped to distinguish previous overvalued run-ups from their subsequent declines.

In contrast, I'm much more skeptical when the assertion “this time it's different” can't even be tested. One example is “it's a New Economy.” To the extent that we've got stock market data spanning the introduction of the automobile, commercial flight, broadcasting, modern medicine, computers, and so forth, the “New Economy” argument is a tough one unless you can display some previously unseen combination of elevated profitability, new innovation, and perpetual barriers to competitive entry. Moreover, we've regularly heard assertions like this at historically extreme valuations, followed by long periods of awful returns. At best, you allow those assertions to feed a healthy skepticism about any particular view, which keeps you from taking positions that would lead to unacceptable losses if you were wrong.

In any event, it's important never to simply assume “it's a bull market” or “it's a bear market” and filter all the data through that perspective. I rarely make forecasts, because it's important not to be too attached to any particular “outlook” or “position.” The commitment of an investor should be to constantly look for the truth of the situation, not to stick to the view the investor had yesterday, regardless of new information.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and unfavorable market action. It was interesting to observe the tepid market response to the “blowout” April employment report. Now, it's hardly a blowout report when job creation does nothing but absorb the number of new workers in the labor force (which is why the unemployment rate was unchanged), but it was not a good sign that the market failed to advance more strongly. The tendency to find a negative spin on seemingly positive news (in this case, inflation fears) is characteristic of unfavorable Market Climates.

Over the past two weeks, the market has cleared the oversold condition it developed after breaking through its prior supporting “shelves” around Dow 10,400 and S&P 1160. As is often the case, the recent rally has taken the major indices back to those prior support levels. So as expected, the behavior of the market over the past couple of weeks hasn't been enormously informative.

At present, however, we're likely to get much more information based on how the market behaves in the weeks ahead. On the negative side, the market has cleared its oversold, which leaves it vulnerable to renewed weakness. Clearly, that's an important risk given that both valuations and market action remain unfavorable on our measures.

That said, however, it's important to allow for the possibility of investors holding in somewhat longer, despite rich valuations. On that note, the Russell 2000 and Nasdaq broke their April lows before recovering somewhat, but the Dow Jones and S&P indices held above those prior lows. We've also seen leadership improve somewhat, with the number of stocks hitting new 52 week highs again surpassing the number of new lows, but both figures are relatively small. All of this is admittedly thin evidence of a firming in internal market action, but it is something, and even subtle clues about investor confidence are worth monitoring here.

Among widely followed measures, favorable developments here would include a further improvement in the Dow Industrials and S&P 500, beyond their prior support levels, a further expansion in new highs versus new lows, improvement in market breadth (advances versus declines), and expanding trading volume on advancing days.

In bonds, the Market Climate remains characterized by modestly unfavorable valuations and modestly unfavorable market action. Junk bond yields are now clearly backing higher. Commercial paper yields aren't yet screaming (as they often do prior to recessions), but are already wider relative to T-bill yields than they were several months ago. The ISM Purchasing Managers Index is also gradually deteriorating. While a PMI of 50 or less is not a reliable indicator of recession in and of itself, in combination with other indicators such as a flat yield curve, widening credit spreads, and a weak stock market, a reading of 50 or below would complete an extremely reliable recession warning composite. We're not there yet, but the potential for economic disappointments continues to exist. A broad improvement in the quality of stock market action would help to reduce the immediacy of that risk.

For now, the Strategic Growth Fund remains fully hedged (with day-to-day returns driven by the difference in performance between our diversified stock holdings and the indices we use to hedge – primarily the S&P 100 and the Russell 2000). The Strategic Total Return Fund carries a duration of just under 2 years (meaning a 100 basis point move in interest rates would be expected to affect the Fund by about 2% on the basis of bond price fluctuations), and an allocation of just under 20% of assets in precious metals shares.

 


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