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February 13, 2006

The Information is in the Divergences

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

Investors familiar with the academic literature of finance are sometimes surprised that, having spent years teaching economics and finance at the University of Michigan, I would place any weight at all on “technical” indicators. The explanation is that my economic views are based on theory involving topics like “asymmetrical information,” “rational expectations,” “signal extraction” and “general equilibrium” – stuff that hasn't, in my view, fully made it into the finance literature.

Very simply, every theorem that says “the stock market efficiently reflects all information” comes hand in hand with a partner called a “no-trade theorem,” which says that no trading ever takes place. These theorems are all based on certain assumptions regarding information, risk preferences, common knowledge, and the ways that individuals process information, and there are all kinds of ways to deviate from the perfection of these assumptions in ways that are plausible. Many of those plausible setups produce stock markets where prices reflect information, but only imperfectly, so that rational individuals do have an incentive to trade, conduct research, and other things that rational individuals actually do in the real world. In those markets, the behavior of prices and trading volume is informative, particularly in combination with private information or research.

Suffice it to say that while I view many technical indicators as useless, badly constructed, or simply misinformed, there are very rigorous theoretical reasons why investors should not ignore the information conveyed by securities prices and trading volume. Theories involving rational expectations and asymmetrical information tend to be mathematically dense (which is the economist's euphemism for “hard and ugly”), but the implications are actually fairly straightforward: securities prices convey information; divergences matter; trading volume reflects differences in information, liquidity needs, or risk tolerance; and “truth” in the financial markets is usually revealed by market action over time, rather than immediately (as implied by strict versions of the efficient markets hypothesis).

Divergences

When information can't be observed directly, you have to infer it from things that can be observed. Statistically, new information is contained in the “forecast error” between what you actually observe, and what you would have expected given the previous data. For example, suppose I give you a series of numbers and ask you to calculate the average. If the average so far is 25, and the next number I give you is 25, your information about the average doesn't change (other than having a little bit more confidence in that average). On the other hand, if the next number I give you is 30, you have new information, and that new information is contained in the divergence between the actual data (30) and what you would have expected given the previous data (25). Most statistical methods can be boiled down to this basic idea – you get your new information from the errors.

In the financial markets, that concept of divergence is essential. It doesn't take most investors long to understand that stock prices generally don't respond much when earnings come in as expected, regardless of whether those earnings are great or terrible. What prices respond to is the “surprise” portion of earnings reports – because that's where the new information is.

Market action also contains information. From a price standpoint, a divergence is simply a difference in the behavior of two securities or groups of securities. If Treasury yields are declining and corporate bond yields are also declining, you take a signal about what those securities share in common: general interest rate conditions. On the other hand, if Treasury yields are declining and corporate bond yields are rising, you take a signal about what those securities don't share: namely credit risk. So divergences in the bond market, in the form of widening “credit spreads” provide a lot of information about the probability of defaults, bankruptcies, and oncoming economic weakness more generally.

Because the divergences, not the raw data, contain the information, I realize that my comments and interpretation of market action can sometimes run counter to the seemingly “obvious” message of the major indices. Of course, any trend that's too obvious should be questioned by investors in the first place. But beyond that, there would be no logical way to act in advance of major movements in the indices if the only basis for action was major movements in the indices. It's the “internal” quality and divergences in market action that conveys early information –not well enough to “time” or “forecast” specific market movements, but well enough to distinguish conditions where market risk has been rewarded, on average, from conditions where it has not.

Though the general character of market action in recent weeks has not been too bad, the NYSE advance-decline line (a running tally of daily advancing issues on the NYSE minus declining issues) has appeared out-of-place in the context of other measures. To get at what's happening internally, it's instructive to compare the overall NYSE advance-decline line with the advance-decline line of the 30 stocks in the Dow Jones Industrial Average, as well as the largest 30 stocks in the S&P 500 Index. Thanks to Bill Hester for the following chart:

Notice the divergence that's been developing since last November. For the past several months, we've been seeing fairly persistent “distribution” in the largest, most highly capitalized stocks in the market, with trades in these large-cap stocks occurring on weak or subdued breadth. Evidently, the enthusiasm of investors for more speculative, smaller capitalization stocks is not reflected in the core issues that comprise the stock market.

In general, divergences like this tend to have a lead-time to them. In other words, the market usually doesn't encounter immediate trouble at the first sign of divergence. It's also possible that the divergence could resolve without incident if large capitalization stocks develop fresh, persistent strength. Still, what's clear is that investors (most likely, institutions) are becoming increasingly selective and restrained about their risk taking. Moreover, the apparently reasonable health of indices like the Dow Industrials and S&P 500 index is presently not confirmed by breadth in these indices.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and relatively neutral market action. That combination of rich valuations and cross-currents in interest rate action, breadth, economic data, inflation pressures, and so forth continues to hold the Strategic Growth Fund to a mostly-hedged investment position, with over 90% of the value of our stock holdings hedged against the impact of market fluctuations at present. The extent of the Fund's hedging will probably fluctuate between 70% and 100% from week-to-week depending on the profile of market action. I wouldn't attempt to forecast short-term direction in any event – on one hand, we've had enough of a selloff to allow for a retest of prior highs. On the other, we're close enough to prior support areas that even a couple of days of negative market action could provoke a substantial increase in defensiveness among investors. This is a market where risk is best held close to the vest.

In bonds, the Market Climate remains characterized by unfavorable valuations and unfavorable market action. Prolonged flatness in the yield curve tends to be an indication of oncoming recession risks, but I don't view a downturn in the economy as imminent. Even a further deterioration in the ISM figures and a widening of credit spreads, if they occur, would probably not suggest weakness until about the third quarter of this year. That said, stocks generally lead the economy lower with a lead of about 6 months, so the potential for further economic stability doesn't imply much about the likely behavior of the stock market. In all, we remain fairly defensive in both the Strategic Growth Fund and the Strategic Total Return Fund. This isn't my preferred investment stance, but unequivocally favorable investment conditions for stocks and bonds occur often enough that there's no reason to over-reach when conditions are far less compelling.

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