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July 17, 2006

Tornado Warnings

John P. Hussman, Ph.D.
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Tornados are more likely to strike when a tornado warning is in effect.

That's probably a statistical fact.

Now, I realize that a tidbit like that probably flies under most people's radar. Not ours. As it happens, that basic idea has everything to do with good investing.

When you've got a tornado warning, you don't necessarily conclude you'll actually get hit by a tornado, but you also aren't surprised if it starts raining. And even if the rain gets heavier, or the wind blows, you aren't surprised again and again. Once you get the tornado warning, you basically allow for the possibility of a tornado. You pack up the garden party and head inside for awhile. Bad news doesn't surprise you. You don't count on it, but you have a subtle expectation that it might arrive.

Financial markets have a particular way of issuing a tornado warning: deteriorating quality of market action across a wide range of market internals. We can observe it through the “heavy” price/volume behavior of recent months, through flagging breadth (advances versus declines), through the poor behavior of interest sensitive securities, and through measures of internal turbulence (industry divergences, large numbers of both new highs and new lows, abrupt flips from new highs dominating to new lows dominating), among others.

And not surprisingly, financial tornados are more likely to strike when such tornado warnings are in effect. When our measures of market action have been unfavorable, as they are now, the stock market has generally followed with unsatisfactory returns, particularly when valuations are also high. Indeed, virtually every significant market crash or panic of note has occurred when market conditions were already characterized by rich valuations and unfavorable internal market action. It's also interesting that the news following periods of unfavorable market action also tends to be broadly unfavorable. Markets are forward looking.

In short, until we observe an improvement in the quality of internal market action (which we don't observe here) we shouldn't be surprised to see news – economic as well as political – having a generally negative tone.

For example, since the 1960's, when our measures of market action have been favorable on balance, the ISM purchasing managers index has increased an average of +0.46% over the following month. In contrast, when market action has been unfavorable, the index has declined an average of -0.68% over the following month. Likewise, surprises to the prevailing inflation rate have averaged -0.23% when market action has been favorable, and +0.30% when market action has been unfavorable. Similar results hold even if we lag the news by an extra month to ensure non-overlapping periods.

We also know that news affects sentiment measures such as consumer confidence and the percentage of bearish investment advisors. These measures give us “summary statistics” of the various concerns influencing consumers and investors in a given month. Historically, when internal market action has been favorable, consumer confidence has increased by +0.64% over the following month, while unfavorable market action has been followed by an average decline of -0.84% in consumer confidence. Similarly, favorable market action has been followed by a contraction in the bearish percentage by -0.38% during the following month, while unfavorable market action has been followed by an average increase in the bearish percentage by +0.46%. Again, similar results hold even if we lag the data.

Financial markets are precisely like tornado sirens. They respond to changing conditions, and are typically already howling before the bad news actually strikes. The quality of internal market action (again, breadth, leadership, industry uniformity or divergence, price/volume behavior, etc) conveys information, and is also an important signal about investors' preferences to accept risk.

Most important for investors, changes in the quality of internal market action not only tend to precede unfavorable news events – they also tend to precede the behavior of the major indices. So if the market is weak on a particular day, we don't necessarily look to the news of that day in efforts to wring out a story (which sometimes forces journalists to use phrases like "shrugged off" and "despite," and even to write stories like - and this was an actual headline last month - "Stocks slide on a lack of economic news"). There might very well be bigger events brewing that haven't made it into the news yet. So the particular news of the day may provide the occasion for the weakness, but it may not actually be the true underlying cause.

Because of this, poor internal market action should presently make us much more inclined to expect unfavorable economic and political news, and also to allow for abrupt or unexpected market weakness. With the major indices now back to a modestly oversold condition, it's certainly possible that we'll observe the typical “fast, furious, prone to failure” rally to clear that oversold condition, but in any event, we haven't observed the sort of improvement in internals that would merit an increase in our willingness to accept broad market risk.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance. Despite what I continue to view as rich valuations overall, an improvement in the quality of internal market action would probably allow us to reduce the Fund's hedges by about 20-25%. Barring that sort of improvement (and none is apparent currently), we have to allow for the possibility of further difficulties for the major indices.

A fully hedged position is not my preference, in the sense that investors in general, as well as Fund shareholders, could expect substantially higher returns if valuations and market action were favorable. Even moderately overvalued conditions but favorable market action, as we saw during the bulk of 2003, would allow us to take a significant exposure to market risk. Similar conditions will arrive in time. They always have, and most probably always will. For now, it's best not to try to speculate on a market advance in a Market Climate that has historically delivered an unsatisfactory return/risk tradeoff on average.

In bonds, the Market Climate was characterized by relatively neutral valuations and neutral market action. These also are not conditions that are permanent or normal, but are part of the normal market cycle that includes both attractive and unattractive conditions. While I do believe that economic conditions are softening, I don't believe that this automatically makes a bullish case for bonds. Such thinking assumes that bond yields will move in a pro-cyclical way, which is only a good assumption if one believes that inflation will also be pro-cyclical (slowing if the economy slows). For reasons I've noted in prior weekly comments, that's not a safe assumption here. Until we observe credit spreads widening, indicating a skittishness toward credit risk that would create a demand for safe government liabilities (cash and Treasury securities), the most likely outlook here is softer economic growth but relatively persistent inflation. The Strategic Total Return Fund retains a duration of about 2 years, mostly in Treasury inflation protected securities, and about 12% of assets in precious metals shares.

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