May 23, 2005
Over the past 7 years, even the depressed returns on risk-free three-month Treasury bills have exceeded the total return on the S&P 500, including dividends. That underscores a basic truth of finance that's often lost in day-to-day and even year-to-year market fluctuations: valuation matters. Specifically, elevated valuations are strongly related to disappointing long-term returns, while depressed valuations are strongly related to impressive long-term returns.
What happens in the interim, however, is far less dependent on the level of valuations. Unfortunately, earnings fluctuations are also relatively useless in explaining short and medium term returns (even over periods of several years). Nor do interest rates or inflation provide a useful fit. What's left, then, is what classical economists called “animal spirits” – what I often refer to as the “risk preference” of investors to either speculate or run for cover.
There are no variables that reliably explain these risk preferences, other than the actions of investors themselves, noisily and imperfectly revealed through the quality of market action. To effectively answer whether investors are concerned about risk or not, you've constantly got to ask where their concerns would show up. Presently, some of the best sources of information, I think, are credit spreads (the difference in yields between risky corporate debt and default-free Treasuries), maturity spreads (long-term yields minus short term yields), interbank spreads (particularly the difference between Chinese yuan interest rates and U.S. dollar LIBOR), market breadth, and trading volume. The interest rate spreads tell us about credit risk, recession risk, and currency risk, while breadth and volume are important here as measures of investor sponsorship.
Among these, interest rate spreads paint a generally unfavorable picture of risk, while market breadth firmed nicely last week, but on trading volume too weak to infer much sponsorship from investors (rallies on low volume tend to reflect short-squeezes and sellers backing away). To the extent that stocks are also overbought here, it's difficult to take much information from that recent firming in breadth. Useful evidence that investors are again eager to accept market risk would come from either a further improvement in breadth on continued high-volume strength, or firm breadth despite weakness in the major averages. Still, my confidence in economic conditions is already busted. There's not enough evidence to anticipate a recession, but risks are clearly increasing, and U.S. lawmakers pining for a yuan revaluation evidently have no clue as to the Pandoras Box they are opening (see Freight Trains and Steep Curves for a refresher).
In contrast, I'm not paying much attention to local fluctuations in oil prices here – the current level is reasonably benign, and isn't likely to have much market effect unless the price pushes the mid-50's again. Likewise, measures such as 52-week highs and lows have to be interpreted carefully, because there's not likely to be much expansion unless either the market breaks the August 2004 lows or we drop that data from the calculation. That said, of course, a return to mid-50's oil prices or a substantial expansion in new lows before August would be surprising, and therefore informative developments.
So we've got cross currents to deal with. The economic picture is clearly increasing in risk, and the evidence is very uniform. Economic difficulties, unfortunately, appear to be mainly an issue of timing. The stock market picture is more nuanced – with unfavorable valuations and an overbought market, yet recent, reasonably broad strength, but tepid trading volume. At times like these, it would be comforting to be able to say “stocks are poised to do well despite the apparent risks,” or “stocks are terribly vulnerable despite the apparent strengths.” Unfortunately, neither determination is possible here. We need additional evidence, which market action will most likely provide in the weeks ahead. For now, the evidence indicates sufficiently high risks and insufficiently low return prospects to justify a continued defensive stance. Yet it's important to remember that our investment position is not bearish – just defensive until and unless more constructive evidence emerges.
As of last week, the Market Climate for stocks was characterized by unusually unfavorable valuations and generally unfavorable market action. It's possible that the market could recruit evidence of a favorable shift in investors' risk preferences in the weeks ahead, but that evidence is not in hand. The Strategic Growth Fund continues to hold a fully hedged investment stance, with the entire value of our stock holdings defended by an offsetting short sale in the S&P 500 [sic] and Russell 2000 indices.
In bonds, the Market Climate remains characterized by moderately unfavorable valuations and market action, holding the Strategic Total Return Fund to a relatively low duration of about 2 years, mostly in Treasury inflation protected securities, with a continued position of slightly less than 20% of assets in precious metals shares responsible for most of the day-to-day volatility in the Fund. The U.S. dollar continues to be substantially overbought, which may at some point produce some abrupt volatility in commodities including oil and precious metals. While the performance of commodities on dollar weakness would probably be strong, it would probably not be smooth, so we may see a sort of two steps – one step type of progress even in the event of strength in natural resource prices.
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