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May 31, 2005

Bull and Bear Markets Exist Only in Hindsight

John P. Hussman, Ph.D.
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What sort of trees are planted at the edge of the Earth? How fast do you have to run to get to the end of a rainbow? Are stocks in a bear market?

It's easy to ask the wrong questions when we don't perceive things as they are.

One of the ways we simplify the world is to form notions and concepts about it. Sometimes this is very helpful. For example, we get a lot of insight from breaking the return on stocks into parts: the return due to dividend income, the return due to long-term growth in fundamentals, and the return due to changes in valuations (P/E multiples and the like). That sort of analysis helps us to understand and explain the source of stock returns, even though investors may not actually be thinking about stocks in this way when they invest.

Other times, we can adopt views and concepts that get in the way of our understanding of reality. We might take a certain amount of data, form an interpretation that seems to make sense, and then cling to that interpretation, abandoning the sort of careful looking that might change our minds. It's important to remember that a certain amount of data can be explained even by bad interpretations. For example, I view the “Fed Model” as a generally invalid tool that draws far too much causality from a single disinflationary period when both interest rates and stock yields fell in tandem. You realize how flawed the model is only if you look more carefully, for instance, by examining longer stretches of history, the model's lack of theoretical validity, and its lack of predictive power (except at a few historical extremes that were identifiable by a variety of other methods).

Even explanatory power does not ensure that our notions are correct. Consider the way that early astronomers once looked at the movements of the planets. Starting from the assumption that everything, including the Sun, orbited the Earth, they devised very complicated theories to explain what they observed. They believed that planets would revolve around the Earth in one direction for a while, then stop, travel backwards in “retrograde motion,” and then continue their orbit. That way of understanding things rested on an incorrect notion that people often force onto reality: the idea that everything revolves around us. But even while we could accurately explain the movements of the planets, you can be certain that the planets were completely free from our incorrect notions about them.

When I was a kid, we lived just off of a golf course. After an afternoon rain, we would often see a large rainbow, which a friend and I tried to chase to its end on at least one occasion. As I learned later, a rainbow moves away from you at exactly the speed you approach it, because it reflects light to the observer's eye at a 42 degree angle to the Sun's rays. With each movement, the rainbow you see is made of entirely different drops of water. The rainbow your friend sees is in a slightly different place altogether, again, at a 42 degree angle to your friend's eyes. So the notion of a rainbow is completely subjective, and though you can clearly see its position with your own two eyes, the rainbow that your friend sees does not agree. Fortunately, knowing all the science doesn't dilute the pleasure of seeing one.

In investing, one of the most common notions is the distinction between bull markets and bear markets. If we examine historical data, we can learn a lot by looking at stocks in those terms. The real problem happens when we forget that bull and bear markets only exist in hindsight, and instead try to apply those concepts in real time.

Regardless of whether you think stocks are in a bull market or a bear market, you can be certain that the stock market does not agree. To ask whether stocks are in a bull market or a bear market is like asking Christopher Columbus what sort of trees he thinks are planted at the edge of the Earth. The whole idea is just plain wrong, because it's based on a false interpretation of reality. Except for a broad historical tendency to fluctuate between extreme overvaluation and deep undervaluation over very long periods of time, the market follows no roadmap. It moves based on the decisions and influences of millions of investors acting day after day, and it has no idea where it will be a year from now.

From past experience, I would guess the market recognizes that when valuations are depressed, it will probably be a great deal higher 7-10 years later, and that when valuations are rich, it will probably spend a long time going nowhere in interesting ways. But the short-term path of the market is not predetermined or forecastable. At best, you can identify the influences operating at any particular point in time. In my view, the most important of those influences are the level of valuation, and the quality of market action. That information isn't enough to make accurate forecasts about where the market will be next month, or next year, but fortunately, it seems to be enough to invest well over time.

In any case, it's not particularly useful to ponder whether stocks are in a bull market or a bear market. Certainly, after the market has moved a large distance in one direction or another, we can eventually say we've experienced a so-and-so, but as soon as investors start using those concepts in a predictive way ("stocks are in a bull market, so..."), they become blind to every bit of conflicting evidence that doesn't come with a swift kick and a hot poker. Bull markets and bear markets don't exist in real time. Better to focus on the influences we can actually observe, which include the level of valuations and the quality of market action. For now, those considerations leave us defensive.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and modestly unfavorable market action. Probably the most positive development in recent weeks has been an improvement in market breadth, as measured by the number of stocks advancing versus declining. Still, other breadth-based measures, such as the McClellan Oscillator, suggest that this improvement may be exhausted and overbought, so the sustained behavior of market breadth will be important to monitor. If investors are moving toward a fresh preference for risk taking, we'll also have to see it in other measures, and that's where the difficulty remains.

Last week's rally, for example, continued to exhibit dull volume. While Friday's weak turnover was easily explained as low pre-holiday trading, we also saw falloffs in trading volume on Monday and Thursday, which were good advances as measured by price strength. Meanwhile, credit spreads continue to widen, the dollar appears overbought following Monday's strength, and the CRB commodities index reversed higher last week, which could put upward pressure on bond yields if it continues. So while we do observe somewhat better breadth, it's difficult to infer a broad improvement in what I'd call “sponsorship” from investors. At least, not enough to conclude that investors have once again adopted a speculative attitude toward risk-taking.

Still, it's important to emphasize that the data are “messy” in the sense of having both favorable and unfavorable elements. Some of that may be resolved either to a more defensive balance or a more constructive one in the weeks ahead, which underscores the importance of identifying prevailing influences rather than forecasting future market conditions. For now, we remain defensive.

In bonds, the Market Climate remains characterized by unfavorable valuations and modestly unfavorable market action, holding the Strategic Total Return Fund to a limited 2-year duration, mostly in Treasury Inflation Protected Securities. Precious metals shares rebounded strongly from their recent lows, and the Fund retains its roughly 20% allocation to that area. I continue to expect that most of the Fund's day-to-day volatility will come from the precious metals sector, which remains in a favorable Market Climate on the basis of valuations and various measures of market action and economic conditions.

There continues to be pressure on China to revalue the yuan. In standard Orwellian fashion, China 's maintenance of a fixed and stable exchange rate with the U.S. dollar is being criticized as “manipulation.” We should be careful what we wish for – the deep current account imbalance with China owes far more to profligate fiscal policy in the U.S. than to unfair currency policies abroad. Sure, the yuan appears undervalued, but before pushing for a revaluation, U.S. policy makers would be really, really smart to get our own fiscal policy in order so we wouldn't be so heavily dependent on foreign capital inflows to finance U.S. economic activity.

Unless that happens, a revaluation of the yuan will do more to stifle growth in U.S. gross domestic investment than any single policy move that Congress could contemplate. Thinking about this in general equilibrium is a disaster: the stuff we buy from China isn't really stuff we make at home, so we'll observe import price increases without enjoying much increased demand for domestic production, the stuff that China competes with us to import (mainly oil), being priced internationally in U.S. dollars, will become cheaper to China, thereby exacerbating energy prices, and the major source of growth in U.S. gross domestic investment in recent years (foreign capital inflows from Asian central banks) will drop off substantially. This is going to be interesting.


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