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October 16, 2006

Temporary versus Permanent Returns

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

Strategy update:

The current Market Climate in stocks is characterized by unfavorable valuations, but modestly favorable market action. Valuations are sufficiently high that we can already conclude that total returns on the S&P 500 over the coming 5-7 years will probably fall short of Treasury bill yields. The current bull market has already lasted beyond the historical norm, and though the S&P 500's percentage gains of the past several years haven't been spectacular from a historical perspective, this has been among the longest periods the market has ever gone without a 10% correction.

Short term, stocks are strenuously overbought as well, which (combined with rich valuations and high levels of advisory bullishness) has historically been associated with weak short-term returns. On the intermediate term, however, we've observed enough improvement in market action to warrant – in the event of short-term weakness – a small exposure (perhaps 1-2% of assets) to index call options in order to “soften” our hedge, provided that market internals remain firm during such a short-term pullback.

Meanwhile, we maintain a strong focus on stock selection. When the Strategic Growth Fund is hedged, our primary source of risk, as well as potential return, is the “basis” or difference in performance between the stocks we hold and the indices we use to hedge. For much of 2006, there was significant overlap between our holdings and the major indices because the highest capitalization stocks were also the best value havens. That overlap reduced the extent to which our stocks could deviate from the indices, but also implied fairly muted returns. In recent weeks, we've had good opportunities to shift to a more typical level of basis risk in the Fund, which can be expected to slightly increase the day-to-day fluctuations in Fund value. But again, that “basis risk” has typically also been the primary driver of returns since the inception of the Fund.

Temporary versus permanent returns

I've noted before that the “median” bull-bear market cycle is 4 years in duration (with a regularity that is typically attributed to the election cycle). Since there's some variation though, the average is closer to 5 years: about 3.75 years of advance, at roughly 28% annualized, and about 1.25 years of decline at roughly -28% annualized. While the individual variations are very wide, an “average” bull market return is 152%, followed by a decline of about -34%, for a total return of about 67% (roughly 10.7% annualized).

It's important to notice what this implies. An average bear market ultimately turns a 152% bull market total return into a 67% total return over the full cycle. That is, less than half of a bull market's trough-to-peak gains are typically preserved when you measure from trough-to-trough. It's hard to emphasize this enough.

Consider even the unusually long advance from December 1994 through September 2000. During that period, the S&P 500 achieved a total return of 277%. During the ensuing bear market decline (to the October 2002 low), the market lost about 46%, resulting in an overall total return of 104% for the complete 8-year period. Even if you take the whole span from 1990-2000 as a single bull market, the ensuing 2-year bear reduced the total return from a 536% total return to a 245% full-cycle return.

In short, bear markets typically nullify over half of the preceding bull market advance. This is helpful to remember as investors rush to chase the speculative tail of an already aged and overvalued bull run.

Defying gravity

Still, market action does provide very useful information about investors' willingness to tolerate overvaluation. Historically, favorable market action (on the basis of breadth, leadership, trading volume, industry action, uniform strength across a wide range of security types, and so forth) has often allowed the stock market to ignore valuations, at least temporarily. This has often allowed seriously overvalued markets to become even more extended for some amount of time.

Think about it. If overvaluation alone was enough to drive stocks lower, we would never observe periods of extreme overvaluation. Clearly, the extreme overvaluations of 1929, 1987 and 2000 were only possible because investors kept speculating despite already high (and ultimately fatal) valuations.

The key is that the market's ability to defy valuations is ultimately temporary. Over the long-term, investors can get perfectly good results by focusing only on valuations and ignoring the quality of market action altogether. Over the short-term, however, this can be very frustrating because the market can defy valuations for months or in some cases years before ultimately wiping out those “speculative” gains by returning to more normal valuations.

I'm keenly aware of the potential for our investment approach to produce this sort of frustration from time to time, and try to limit it as much as possible. However, I'm also keenly aware of the value that our shareholders place on risk management and capital protection. My primary objective is to achieve strong returns over the full market cycle (bull and bear market combined), with added emphasis on risk management. I would much rather experience a transitory period of underperformance than to “time” or “chase” a rally, and in so doing, open our shareholders up to a significant loss of capital in an already overvalued, overbought market.

That doesn't mean that we'll accept no market risk at all here, but rather that I have no intention of exposing the Fund to material downside risks by eliminating our hedge positions. Whatever exposure to market risk we take at present is likely to amount to 1-2% in call option premiums.

Appropriate speculation

In my work, I distinguish favorable valuations (“investment merit”) from favorable market action (“speculative merit”). In some cases, favorable market action contains information about future improvements in fundamentals. In other cases, favorable market action just suggests that investors are willing to speculate on some “concept.” It's likely that the current rally represents pure speculation, based on hopes of a “Goldilocks” economy. Though I continue to believe the Goldilocks thesis is entirely wrong, it may take weeks or even months for enough data to emerge to contradict it. In the meantime, you can't simply stand in front of investors saying “No. Stop. Don't. This will end badly.” To paraphrase Warren Buffett, “a herd of lemmings looks like a pack of individualists compared with Wall Street once it gets a concept in its teeth.”

Accordingly, it can be reasonable to accept at least some speculative exposure to market fluctuations on the basis of favorable market action alone, even when favorable valuations are lacking. The extent of that risk-taking is determined by a range of factors including the actual level of valuations, the short-term position of the markets (e.g. overbought or oversold), economic conditions, and broad strength and uniformity market internals. The more “robust” these factors are, the larger a speculative position you accept. The more tenuous and fragile these conditions, the smaller the speculation you accept.

Despite the new highs in the Dow Industrials, the general quality of market action is currently only modestly favorable overall – note, for example, that in recent weeks, the number of stocks achieving weekly new highs hasn't exceeded the levels seen in the January-May period. Meanwhile, the decline in bond yields – which formed the backbone of the recent rally – has reversed enough to put general yield trends back to a neutral condition by our measures. So overall, the favorable condition of market action has to be qualified by “modestly.” Conditions aren't robust enough to warrant a large exposure to market fluctuations.

As a result, the Strategic Growth Fund's exposure to market fluctuations here is likely to take the form of a 1-2% exposure to index call options. This would have the effect of “softening” the impact of our fully hedged investment position, by allowing exposure to general market advances without significantly reducing our defense against market losses. With implied option volatilities at very low levels, the time decay of such option positions in the event of a flat market is fairly small.

The Fund presently holds a fraction of 1% in index call options. As always, it's our discipline to add to desired positions on short-term weakness rather than chasing strength when prices are already strenuously overbought. I expect to add to our option positions primarily on short-term market pullbacks (in the range of say, 1-4%). If the market weakens enough to place our measures of market action back to an unfavorable condition, we'll quickly shift back to a fully hedged position by liquidating that small call position.

10% corrections

Even barring a full-fledged bear market, it's notable that the Dow has now gone over 900 trading days without even a 10% correction. The current advance is among the 5 longest uncorrected advances on record. The accompanying table indicates all prior instances where the Dow advanced more than 600 trading days without a 10% correction, along with the price/peak earnings ratio of the S&P 500 and the 10-year Treasury bond yield at the market high, and the extent of the ensuing decline. The declines listed don't necessarily represent bear markets, but only the extent of Dow losses before the next 10% advance (which in many cases was followed by yet another plunge).

Date

Trading Days

P/E at high

T-bond yield

Decline

09/03/1929

719

20.6

3.8%

-40.0%

03/10/1937

654

11.3

2.5%

-14.9%

05/29/1946

1020

16.2

2.1%

-23.2%

01/05/1953

617

9.4

2.8%

-13.0%

07/12/1957

960

13.0

3.7%

-19.4%

02/09/1966

912

17.6

4.6%

-25.2%

08/25/1987

780

19.7

8.9%

-36.1%

07/16/1990

657

13.6

8.6%

-21.2%

08/06/1997

1723

23.7

6.4%

-10.6%

10/13/2006

906

18.3

4.8%

 

Contrary to popular belief, the bulk of history has been accompanied by lower P/E ratios as well as lower interest rates than we presently observe. Neither of these conditions prevented extended market advances from being punctuated by significant declines.

Suffice it to say that even if the market was to advance further by 10% or more (which I view as improbable), the likelihood of investors actually retaining the gain would be fairly negligible. We'll accept those risks that are appropriate, but there's no sense running off to juggle dynamite with the other kids, just because they're having fun right now.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations and modestly favorable market action. The implications of this for the long, intermediate and short-term are reviewed below.

On a long-term basis, we know that rich valuations are closely associated with disappointing long-term returns. Investors can certainly get good results focusing on long-term valuations alone, but as I noted earlier, that can also be very frustrating because it can invite extended periods when the “value-only” approach lags the market. For this reason, we do accept a "speculative" exposure to market flucutations if our measures of market action are sufficiently favorable.

Indeed, on an intermediate term basis, the current overvaluation is mitigated somewhat by a modestly favorable tone to market action. That's sufficient to warrant a small call option position to “soften” our fully hedged stance. If the market can pull back moderately without losing its favorable internals, I would expect to increase that call position to 1-2% of net assets.

On a short-term basis, despite the modestly favorable tone of market action, the status of the market at the moment can be classified as “overvalued, overbought, and overbullish.” The S&P 500 currently trades at 18.3 times record earnings (on record profit margins), stocks are clearly overbought on the basis of a variety of technical measures, and advisory bulls exceed 50%. Historically, this set of conditions has been associated with short-term market losses, on average, even when our broader measures of market action have been favorable.

So, we've got unfavorable long-term valuations, a modestly favorable Market Climate in the intermediate term, and on a short-term basis, a strenuously overbought condition, which if corrected, would allow us to modestly increase our small speculative call position.

In bonds, the Market Climate last week was characterized by modestly unfavorable valuations and relatively neutral market action. The Strategic Total Return Fund continues to hold a short-duration position (about 2-years) mostly in Treasury inflation protected notes, and as a position in precious metals shares of just over 20% of assets.

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