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January 16, 2006

Overvalued, Overbought, Overbullish

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

The title of this week's comment more or less speaks for itself. At present, the S&P 500 trades at well over 19 times a record level of earnings. Historically, record earnings for the S&P 500 have been accompanied by an average price/earnings ratio of 12. Meanwhile, the S&P 500 is overbought not only on a short-term basis but also on a fairly long-term basis – another way of saying that the bull market is fully extended and now beyond the typical length for prior bull runs. Finally, Investors Intelligence reports that 56.8% of investment advisors are bullish, compared with just 22.1% bearish (other sentiment indicators such as the CBOE volatility index continue to show similar complacency).

[Note that we use trailing net earnings based on generally accepted accounting principles – GAAP – it's becoming endemic to quote P/E ratios on the basis of year or two-year ahead projected operating earnings and then compare the resulting P/E with historical averages based on trailing net earnings. Investors neither seem to know nor care much about that sort of error, so long as it results in optimistic forecasts.]

On average, this set of overvalued, overbought and overbullish conditions has historically produced tepid results even when the broad quality of market action has been favorable on the measures we use, and has been downright mean when the internal quality of market action is unfavorable (such periods include February 1962, December 1972, and August 1987, all which shortly preceded violent declines). Given current conditions, the quality of market action is best described as either tenuously unfavorable or neutral, so in any event, market risk hardly appears worth taking at present.

Given that the current, tepid condition of the market is fairly independent of the quality of market action, it might seem that we could all just go out for a bite and come back to watching the markets at some point in the future, but it's actually a fairly exciting time right now. What the market does over the next week or two may convey information that makes a difference to our investment position.

Specifically, a market decline in the next week or so on very poor breadth (a preponderance of declines over advances) and a quick negative shift in leadership (new 52 week lows outnumbering new 52 week highs) would be a major red flag, and very possibly the start of a protracted downturn in the markets. It's sufficient to recall the handful of prior periods like February '62, December '72 and August '87 to recognize that a powerful breadth and leadership reversal, given current conditions, would be a fairly strong alarm.

On the other hand, if the market can retreat from its overbought condition while preserving a good amount of internal strength (again, breadth and leadership should be fairly informative even without resorting to more elaborate indicators), it would allow us to infer that investors have adopted a robust preference to accept market risk, and that the change was more than a knee-jerk reaction to the possibility of a more friendly Federal Reserve. That's not to say that the long-term outlook for market returns would be any brighter, but it would help to justify at least a moderate speculative exposure to market risk, say 20-30% of portfolio value.

In short, present conditions don't provide much support for taking market risk, but the next few weeks could be very informative. If the market can experience a reasonable pullback without suffering a strong reversal in internal quality, we would have enough evidence to warrant a moderate exposure to “beta” risk. In contrast, a strong reversal in breadth and leadership in the coming weeks would be a potentially very negative indication. All very much worth watching.

In bonds, the Market Climate remained characterized last week by unfavorable valuations and unfavorable market action, holding the Strategic Total Return Fund to a relatively short 2-year duration. I further reduced the Fund's exposure in precious metals shares on last week's price strength, combined with reasonable firmness in the ISM statistics and moderate inflation figures. My impression is that we'll rebuild that precious metals position at some point in the coming months, preferably on price weakness coupled with sluggish economic signals, but here and now, I'm comfortable with a pared-down exposure to precious metals, which presently represent less than 10% of assets in the Strategic Total Return Fund.

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In memory of Dr. Martin Luther King, Jr.

Excerpted from a sermon titled “The three dimensions of a complete life”

Somewhere along the way, we must learn that there is nothing greater than to do something for others. And this is the way I've decided to go the rest of my days… I don't know how long I'll live, and I'm not concerned about that—but I hope I can live so well that the preacher can get up and say, "He was faithful." That's all, that's enough. That's the sermon I'd like to hear: "Well done my good and faithful servant. You've been faithful; you've been concerned about others." That's where I want to go from this point on the rest of my days. "He who is greatest among you shall be your servant." I want to be a servant. I want to be a witness for my Lord, to do something for others.

And don't forget in doing something for others that you have what you have because of others. Don't forget that. We are tied together in life and in the world. And you may think you got all you got by yourself. But you know, before you got out here to church this morning, you were dependent on more than half of the world. You get up in the morning and go to the bathroom, and you reach over for a bar of soap, and that's handed to you by a Frenchman. You reach over for a sponge, and that's given to you by a Turk. You reach over for a towel, and that comes to your hand from the hands of a Pacific Islander. And then you go on to the kitchen to get your breakfast. You reach on over to get a little coffee, and that's poured in your cup by a South American. Or maybe you decide that you want a little tea this morning, only to discover that that's poured in your cup by a Chinese. Or maybe you want a little cocoa, that's poured in your cup by a West African. Then you want a little bread and you reach over to get it, and that's given to you by the hands of an English-speaking farmer, not to mention the baker. Before you get through eating breakfast in the morning, you're dependent on more than half the world. That's the way God structured it; that's the way God structured this world. So let us be concerned about others because we are dependent on others.

But don't stop here either. You know, a lot of people master the length of life, and they master the breadth of life, but they stop right there. Now if life is to be complete, we must move beyond our self-interest. We must move beyond humanity and reach up, way up for the God of the universe, whose purpose changeth not.

Now a lot of people have neglected this third dimension. And you know, the interesting thing is a lot of people neglect it and don't even know they are neglecting it. They just get involved in other things. And you know, there are two kinds of atheism. Atheism is the theory that there is no God. Now one kind is a theoretical kind, where somebody just sits down and starts thinking about it, and they come to a conclusion that there is no God. The other kind is a practical atheism, and that kind goes out of living as if there is no God. And you know there are a lot of people who affirm the existence of God with their lips, and they deny his existence with their lives.

You've seen these people who have a high blood pressure of creeds and an anemia of deeds. They deny the existence of God with their lives and they just become so involved in other things. They become so involved in getting a big bank account. They become so involved in getting a beautiful house, which we all should have. They become so involved in getting a beautiful car that they unconsciously just forget about God. There are those who become so involved in looking at the man-made lights of the city that they unconsciously forget to rise up and look at that great cosmic light and think about it—that gets up in the eastern horizon every morning and moves across the sky with a kind of symphony of motion and paints its technicolor across the blue—a light that man can never make. They become so involved in looking at the skyscraping buildings of the Loop of Chicago or Empire State Building of New York that they unconsciously forget to think about the gigantic mountains that kiss the skies as if to bathe their peaks in the lofty blue—something that man could never make. They become so busy thinking about radar and their television that they unconsciously forget to think about the stars that bedeck the heavens like swinging lanterns of eternity, those stars that appear to be shiny, silvery pins sticking in the magnificent blue pincushion. They become so involved in thinking about man's progress that they forget to think about the need for God's power in history. They end up going days and days not knowing that God is with them.

And I'm here to tell you today that we need God. Modern man may know a great deal, but his knowledge does not eliminate God. And I tell you this morning that God is here to stay. A few theologians are trying to say that God is dead. And I've been asking them about it because it disturbs me to know that God died and I didn't have a chance to attend the funeral. They haven't been able to tell me yet the date of his death. They haven't been able to tell me yet who the coroner was that pronounced him dead. They haven't been able to tell me yet where he's buried.

You see, when I think about God, I know his name. He said somewhere, back in the Old Testament, "I want you to go out, Moses, and tell them ‘I Am' sent you." He said just to make it clear, let them know that "my last name is the same as my first, ‘I Am that I Am.' Make that clear. I Am." And God is the only being in the universe that can say "I Am" and put a period behind it. Each of us sitting here has to say, "I am because of my parents; I am because of certain environmental conditions; I am because of certain hereditary circumstances; I am because of God." But God is the only being that can just say, "I Am" and stop right there. "I Am that I Am." And He's here to stay. Let nobody make us feel that we don't need God.

As I come to my conclusion this morning, I want to say that we should search for him. We were made for God, and we will be restless until we find rest in him… Somewhere I read, "The earth is the Lord's and the fullness thereof, and I'm going on because I have faith in Him. I do not know what the future holds, but I do know who holds the future. And if He'll guide us and hold our hand, we'll go on in.

Excerpted from a sermon titled “Love your enemies”

It's not only necessary to know how to go about loving your enemies, but also to go down into the question of why we should love our enemies. I think the first reason that we should love our enemies, and I think this was at the very center of Jesus' thinking, is this: that hate for hate only intensifies the existence of hate and evil in the universe. If I hit you and you hit me and I hit you back and you hit me back and go on, you see, that goes on ad infinitum. [ tapping on pulpit ] It just never ends. Somewhere somebody must have a little sense, and that's the strong person. The strong person is the person who can cut off the chain of hate, the chain of evil. And that is the tragedy of hate, that it doesn't cut it off. It only intensifies the existence of hate and evil in the universe. Somebody must have religion enough and morality enough to cut it off and inject within the very structure of the universe that strong and powerful element of love.

I think I mentioned before that sometime ago my brother and I were driving one evening to Chattanooga , Tennessee , from Atlanta . He was driving the car. And for some reason the drivers were very discourteous that night. They didn't dim their lights; hardly any driver that passed by dimmed his lights. And I remember very vividly, my brother A.D. looked over and in a tone of anger said: "I know what I'm going to do. The next car that comes along here and refuses to dim the lights, I'm going to fail to dim mine and pour them on in all of their power." And I looked at him right quick and said: "Oh no, don't do that. There'd be too much light on this highway, and it will end up in mutual destruction for all. Somebody got to have some sense on this highway."

Somebody must have sense enough to dim the lights, and that is the trouble, isn't it? That as all of the civilizations of the world move up the highway of history, so many civilizations, having looked at other civilizations that refused to dim the lights, and they decided to refuse to dim theirs. And Toynbee tells that out of the twenty-two civilizations that have risen up, all but about seven have found themselves in the junk heap of destruction. It is because civilizations fail to have sense enough to dim the lights. And if somebody doesn't have sense enough to turn on the dim and beautiful and powerful lights of love in this world, the whole of our civilization will be plunged into the abyss of destruction. And we will all end up destroyed because nobody had any sense on the highway of history. Somewhere somebody must have some sense. Men must see that force begets force, hate begets hate, toughness begets toughness. And it is all a descending spiral, ultimately ending in destruction for all and everybody. Somebody must have sense enough and morality enough to cut off the chain of hate and the chain of evil in the universe. And you do that by love.

There's another reason why you should love your enemies, and that is because hate distorts the personality of the hater. We usually think of what hate does for the individual hated or the individuals hated or the groups hated. But it is even more tragic, it is even more ruinous and injurious to the individual who hates. You just begin hating somebody, and you will begin to do irrational things. You can't see straight when you hate. You can't walk straight when you hate. You can't stand upright. Your vision is distorted. There is nothing more tragic than to see an individual whose heart is filled with hate. He comes to the point that he becomes a pathological case. For the person who hates, you can stand up and see a person and that person can be beautiful, and you will call them ugly. For the person who hates, the beautiful becomes ugly and the ugly becomes beautiful. For the person who hates, the good becomes bad and the bad becomes good. For the person who hates, the true becomes false and the false becomes true. That's what hate does. You can't see right. The symbol of objectivity is lost. Hate destroys the very structure of the personality of the hater… Hate at any point is a cancer that gnaws away at the very vital center of your life and your existence. It is like eroding acid that eats away the best and the objective center of your life. So Jesus says love, because hate destroys the hater as well as the hated.

Now there is a final reason I think that Jesus says, "Love your enemies." It is this: that love has within it a redemptive power. And there is a power there that eventually transforms individuals. That's why Jesus says, "Love your enemies." Because if you hate your enemies, you have no way to redeem and to transform your enemies. But if you love your enemies, you will discover that at the very root of love is the power of redemption.


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