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August 1, 2005

Late-Stage Bull Markets - Overvaluation, Divergence and Speculation

John P. Hussman, Ph.D.
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Before the arrival of computers, it was not uncommon for people to dedicate a life's work to indexing every word of important texts, in order to help future scholars search for particular words and phrases. One of these efforts, an index of Byron's literary works, was started in 1940. Twenty five years later, the author conceded that his life's work “may well be considered the last” of these hand-made efforts, which by then could be created by a computer in a few days*. Still, the scholar noted that “the pleasure of working with Byron's poetry would have been lost on a machine.”

That benefit of working with things day-to-day applies to a lot of pursuits, including investing. My college job in the early 80's was maintaining price and volume charts by hand, which can now be done in nanoseconds. If you stare at market data for a good part of each day, after about twenty five years, you get a feel for what seems valid and what, for lack of a better phrase, “feels funny.” In his latest book, Blink, Malcolm Gladwell quotes the son of famed hedge fund investor George Soros as saying “My father will sit down and give you theories to explain why he does this or that. But I remember seeing it as a kid and thinking, at least half of this is bull. I mean, you know, the reason he changes his position on the market or whatever is because his back starts killing him. He literally goes into a spasm, and it's this early warning sign.”

In recent weeks, one of the things that has constantly “felt funny” has been the disconnect between the NYSE advance-decline line, which has advanced persistently, and my subjective impression of market action from watching the behavior of individual stocks and industry groups day-by-day. Thankfully, my back doesn't start killing me when this happens. It's just that the A-D line has been looking strange, even “foreign” to me. Since I'm not a big fan of “analysis by feeling,” I've been asking myself whether there's objective evidence behind my discomfort with the cheery disposition of the A-D line. For reference, here's a chart (the NYSE advance-decline line is the running total of advancing issues minus declining issues each day on the New York Stock Exchange). Thanks to Bill Hester for his assistance preparing the data and graphics in this update.

The clear “look” of this chart is that the market is “in synch” and that there is no evidence of internal turbulence. Now, in late-stage bull markets, we tend to observe two events. One is a loss of what I call uniformity – breadth (on various measures such as the advance-decline line) typically “rolls over” and starts to diverge from the action of the major indices. The second is that we tend to observe what's called a “speculative blowoff,” as investors become increasingly impatient with anything but fast money.

Last week, it struck me that these two events might be occurring here, despite the “look” of the NYSE advance-decline line. Though my day-to-day observation of individual stocks gives me the impression that market internals are, in fact, divergent and sloppy, maybe the A-D line is masking that somehow. Maybe the strong advance-decline line isn't a picture of uniformity at all, but is being driven higher because investors and institutions are chasing performance in speculative stocks. Maybe the behavior of the A-D line has gotten mixed up with a small-cap “blowoff.”

How could you tell? You could explicitly separate the breadth of the largest stocks from the breadth of smaller ones. That insight is owed to Richard Russell, who in the late 90's devised a “big money breadth index” consisting only of the largest 10 stocks of the market, in order to focus on the behavior of the market's most dominant stocks during the bubble.

In the present case, we can look at the largest 30 stocks in the S&P 500, the 30 stocks in the Dow Industrials (only some which overlap the S&P 500 group), and the largest 30 stocks in the small-cap Russell 2000 index. If in fact, the market is “in synch,” we should observe the same basic uptrend in each of these groups that we observe for the NYSE advance-decline line as a whole. Instead, we observe nothing of the sort.

Rather than uniform strength, we've been observing persistent distribution in large capitalization stocks ever since December 2004. Large capitalization breadth has glaringly failed to confirm the recent advance. In effect, the apparent strength in market breadth is little more than a speculative chase after small-cap momentum. No matter that small caps are overextended – this is where the “fast money” wants to be.

In short, we're observing precisely the combination of overvaluation, internal divergence and momentum-based speculation that is the hallmark of late-stage bull markets.

During the late 90's, the market's final speculative frenzy focused on a narrow group of large-cap tech stocks, which boosted indices such as the S&P 500 and Nasdaq, even as small-cap stocks languished and the NYSE advance-decline line slipped lower. During the present cycle, in contrast, investors are focusing their speculation on a large number of small-cap stocks because that's where the momentum has been, which actually helps the NYSE advance-decline line to appear strong despite clear internal turbulence.

Worse, when you restrict your attention to small caps alone, the behavior of investors looks almost cartoonish. It's not just any small caps that investors want. It's the ones that belong to the specific indices that are performing well. In other words, investors (and most probably mutual fund managers) seem to be literally buying their stocks off of a shopping list, the most preferable being the components of the Russell 2000 index.

How can you tell? Take a look at the smallest 30 stocks in the S&P 500, versus the largest 30 stocks in the Russell 2000. These stocks, as it happens, have very similar market capitalizations, but even their market action is profoundly divergent.

Going back to the NYSE advance-decline line, we can perform the same analysis, but restrict our choice of stocks to those that are listed on the NYSE (since many of the largest stocks in the Russell 2000 index are traded on the Nasdaq). Even with a different list of stocks, nothing changes in the analysis. For example, the chart below is similar to the previous one, but presents the advance-decline lines of the smallest 30 stocks in the S&P 500 (NYSE only) versus the largest 30 stocks in the Russell 2000 (NYSE only). Again, these stocks have very similar market capitalizations, but nowhere near the same behavior in terms of breadth.

In short, despite the apparent serenity of the NYSE advance-decline line, the market is already exhibiting the sort of internal turbulence and speculative characteristics that are hallmarks of late-stage bull markets. That's not to make any pointed forecast that stocks will or must turn down any time soon. Rather, the point is to emphasize that there are emerging signs of distribution in market action that investors shouldn't ignore.

As I've frequently noted, the refusal to follow indicators blindly is the difference between analysis and superstition. The objective is always to understand reality, and investors shouldn't rely on any particular indicator without a firm understanding of why it should be useful and the mechanism behind it. In my view, it is superstition to believe that all is well in the market because NYSE breadth is strong here.

At least my back feels OK.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and relatively neutral market action. The divergences noted above are certainly important, and with the major indices overbought, investors shouldn't rule out the possibility of market losses here. Still, it's typical to see even more internal deterioration prior to an extended decline in the major indices. As noted in the July 18th comment, there is currently a “skew” to the probable distribution of market returns: the most likely event in terms of sheer probability is for the market to hold up a while longer, continuing to achieve marginal new highs, but that probability is offset by a small but “above-normal” potential for serious damage, leaving the overall expected return/risk tradeoff unsatisfactory. While the precise exposure of the Strategic Growth Fund to market fluctuations changes based on day to day opportunities, the Fund maintains a significant, though presently slightly less than full hedge, against the impact of market fluctuations here.

If investors don't keep valuations, skew, and other factors in mind, it may be relatively easy to get sucked in by the continual talk of “4-year highs,” while forgetting that the annualized total return on the S&P 500 over those 4 years has been just 2%, and that the index still shows a negative return over 5 years. Suffice it to say that I don't find the talk of 4-year highs, economic sweet spots, and “great earnings” overly compelling.

In bonds, the Market Climate remains characterized by unfavorable valuations and slightly unfavorable market action. Credit spreads have stabilized somewhat, which is actually a slight negative for Treasuries, and yields have entered a choppy sideways trend that takes away some of the self-reinforcing downward pressure on bond yields from “duration gap ” trades. Essentially, as bond yields decline, mortgage refinancings tend to increase, which shortens the duration of assets held by lenders such like Fannie Mae and banks more generally. In order to replace that duration, these lenders buy long-dated Treasuries, which exacerbates the upward pressure on bond prices and the downward pressure on yields. With the enormous overhang of mortgage debt, that sort of action has become much more common, which creates sporadic volatility in bond yields.

Unfortunately, unless one believes that very nimble forecasts are possible in the bond market (I don't), the prospect of this sort of volatility does little for the average return that one can expect from fixed income investments. So the result is a less satisfactory return/risk profile. For now, the Strategic Total Return Fund maintains a relatively short duration of just under 2.5 years, mostly in inflation protected Treasuries, with about 20% of assets in precious metals shares.

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* Ian Witten, Alistair Moffat & Timothy Bell, Managing Gigabytes, 1999

 


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