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November 6, 2006

Chasing the Bull's Tail

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

With stocks still near their recent highs, I think it's useful to remember the tendency of bull markets to surrender large portions of their gains over the full market cycle. Without that understanding, investors are vulnerable to the temptation to “chase” returns in what is already a richly valued, aged bull market advance, where recession risks continue to gradually increase.

The table below lists a dozen market advances that have accounted for all of the net postwar gain in the S&P 500 index. The table is based on weekly data, with market declines of at least 10% separating the advances.

“Bull Gain” represents the bull-market-only portion of a cycle, while “Full Cycle” shows the portion of the gain that was still retained when the market reached its subsequent low. P/PE shows the price/peak earnings multiple of the S&P 500 at the start and end of those bull runs.

          Low

              Peak

    Bull Gain

    Full Cycle

        P/PE
        at Low

        P/PE
        at High

05/17/47

06/11/48

31.1%

13.6%

9.5

9.1

06/10/49

07/27/56

434.4%

354.1%

5.8

13.3

12/20/57

12/01/61

108.2%

55.4%

10.7

19.5

06/22/62

02/04/66

98.3%

59.2%

14.3

17.7

10/07/66

12/22/68

55.5%

11.1%

12.7

18.1

10/04/74

12/23/76

84.5%

62.7%

7.0

11.1

03/03/78

02/01/80

45.9%

28.7%

8.2

7.9

04/18/80

11/21/80

42.7%

16.9%

6.8

9.1

08/06/82

08/14/87

296.3%

168.3%

7.8

19.9

12/04/87

07/16/90

75.4%

48.3%

13.4

13.5

10/12/90

07/10/98

374.0%

244.8%

11.3

28.0

10/04/02

10/27/06

85.1%

n/a

15.3

18.4

A few recognized bull market advances aren't included in the table at all. These include the rallies from May 1970 to April 1971, from November 1971 to December 1972, and from September 1998 to March 2000, all whose gains were entirely wiped out by subsequent declines. (The peak date of 10/27/06 is provided only for reference, not as a market call.)

A few things are worth noticing. First, when we include those periods where bull gains were completely eliminated by subsequent declines, we find that less than half of bull market gains are typically retained over the full market cycle. As I noted two weeks ago, if we take the market's advance from October 1990 through March 2000 as a single bull run, we find that the ensuing decline took the S&P 500 from a bull market return of over 500% to a full cycle return of about 240%. It just doesn't pay to frantically chase the tail of a bull market, particularly once stocks have become richly valued.

Second, notice that bull markets don't start or end at set multiples. Loosely speaking, rallies often started at price/earnings ratios of 11 or less (often in the single digits), and usually ended by the time price/peak earnings ratios approached 17-19 (though the average is closer to 15). Even so, the bull gains have a 90% correlation with the extent to which P/E multiples increased, which was clearly easier when valuations began at low levels. By comparison, the most recent bull market advance from the October 2002 low began at 15.3 times peak earnings, already the highest multiple on record for the start of a bull market advance. The multiple is now in the upper range where prior bull advances have ended.

Looking at the table, you'll note that only three of the bull market periods retained more gains than what the S&P 500 has already achieved in this advance, and all three involved a more than doubling of the market's P/E ratio from a low starting level. It seems unrealistic optimism to expect the market to make further upside progress from here, and actually keep it over the completion of this market cycle, or without at least a 10% correction. Indeed, all of the prior rallies that ended at a P/E above 18 were followed by declines of at least 25%.

Moreover, the current multiple of 18.4 is actually much more extreme than it appears, because that elevated multiple is being applied to an earnings figure based on record profit margins. Historically, investors have not been rewarded for paying rich multiples on rich profit margins. We're already observing “surprising” wage inflation which is likely to place downward pressure on these margins.

At points like this, our investment approach takes the potential risk of market losses very seriously. When there is a high likelihood of further market gains being erased over the complete cycle, then accepting market risk is not an “investment” proposition, but a “speculative” one. Given that the quality of market action is reasonably favorable at present, we're willing to devote 1-2% of our assets to speculative positions in index call options, but unless the market advances in a strong and sustained fashion, my impression is that these positions are likely to have only a modest impact on returns. In a richly valued market with wage inflation emerging and recession risks increasing, our hedging is where it should be – mostly defensive, with a slight constructive bias.

Notes on recent Fund performance

In the past couple of weeks, we've started to receive one or two calls a day from investment advisors or financial planners who hold the Strategic Growth Fund for their clients. It's always my assumption that if we get a question more than once, it may be on the minds of many more shareholders, so I try to address it in these weekly comments.

In this case, the question goes something like this. “We're long-term investors in the Strategic Growth Fund, and we share your perspective on valuations and measuring returns over the full cycle, but we also report regularly to our clients and want to be able to explain why the Fund is only up a few percent this year.”

Completely fair question. Part of the explanation, of course, is that we're well-hedged against market risk and rich valuations (which continue to be a concern). But much of it actually has to do with a brief period of modestly lagging stock selection. That's not particularly unusual – despite our strong stock selection record, our stocks occasionally lag the market over the short-term. But when you couple that modest 6-month lag with a hedged investment position, the net result has been a fairly dull gain in recent months.

After more than two decades in the investment services, I'm familiar with the “champ to chump, chump to champ” cycle. Properly done, a good hedging strategy will typically increase market exposure approaching and slightly after a major low, and it will hedge too early, because the costs of getting out even a little bit too late can be extreme. This means that good risk managers regularly appear to be idiots at market tops, geniuses at market lows, and hopefully, serve their clients very well over the course of a complete market cycle.

After performing well during the 2000-2002 bear market, we properly lifted most of our hedges in early 2003. Once the market got back to extreme valuations in early 2004, we again hedged our stock holdings due to the tendency of the market to underperform T-bills over time from such valuations. Since then, the S&P 500 has maintained its rich valuations somewhat longer than usual, outperforming T-bills by about 5% annually, measured to the recent market high.

So recent hindsight does not look kindly on our defensive position, particularly since stocks have enjoyed a strong “blowoff” rally since mid-July, and we haven't participated much in that. Of course, we don't hold ourselves out as “market timers” and don't place much weight on tracking short-term market movements. Our objective is, and remains, to achieve strong returns over the complete market cycle. When you realize how much of the gain in a bull market is typically surrendered in a bear market, it becomes clear that chasing short-term rallies in richly valued markets isn't helpful to long-term investment success.

On the stock selection side, it's clear from our performance history that we've generally benefited from a positive performance margin between our stocks and the indices we use to hedge. However, that strong overall record can obscure the fact that our stocks generally lag the market about a third of the time, a ratio that's typical of many good stock pickers. That's the result of fairly random fluctuations – if you carry a portfolio of over 100 stocks, composed differently than the major indices, the behavior of those stocks may not closely track or outperform those indices over short periods.

That's been the case between the market's May 5th high its late October high. From May 5th through the end of October, the S&P 500 declined, then recovered and pushed to marginal new highs, producing a total return of 4.87%. Our holdings also declined and recovered, but the net gain in our stock holdings (excluding the impact of hedging) from peak-to-peak has been 1.52%. While that's not the sort of relative showing that I'd want to achieve for shareholders over a full cycle, and it's not “typical” in the sense that our stock selection has typically outperformed the major indices, a -3.36% lag in performance over a volatile 6-month period isn't any sort of extreme outlier either.

Now, year-to-date through October 31, 2006, the Strategic Growth Fund achieved a total return of 3.38%. Had our stock selections matched the S&P 500 during the May-October period, we would be looking at a total return of about 6.74% even with the hedge. That's a small comfort, of course, but I do believe that such short-term fluctuations average out over time.

Earlier this year, virtually the only stocks with good sponsorship (on the basis of price/volume behavior) were lower quality “garbage stocks”. While that left us holding “deep value” for much of the year, we've had what I view as very good opportunities in recent weeks to pare our lower ranked holdings on short-term strength and to purchase new holdings that still appear to have reasonable valuation, but also better investor sponsorship. I continue to believe that both our stock selections and our hedging position are appropriate given the current market environment. As usual, outside of a few percent in money market funds for liquidity purposes, all of my personal investments remain in the Strategic Growth Fund and the Strategic Total Return Fund.

For disclosure purposes, as of October 31, 2006, the Strategic Growth Fund achieved annual total returns of 3.88%, 6.05%, 10.65% for the most recent 1, 3 and 5 year periods, respectively. The average annual total return of the Strategic Growth Fund since its inception on July 24, 2000 was 12.71%. Past performance does not ensure future returns, and the value of the Fund will fluctuate so that an investor's shares, when redeemed, may be higher or lower than their original cost.

Market Climate

As of last week, the Market Climate in stocks remained characterized by unfavorable valuations and moderately favorable market action. That favorable market action remains a sign that investors have a “speculative” preference toward risk-taking. Until market internals deteriorate, that sort of preference will be enough to warrant at least a modest speculative exposure to market risk, which we prefer to accept by taking a 1-2% exposure to index call options. That's a clearly “asymmetrical” position in the sense that we've got a modest exposure to market advances, but any abrupt market decline shouldn't cost us much. The cost of that asymmetry is that our call options will experience modest time-decay if the market remains relatively unchanged, but that decay is currently very small, due to the low level of implied option volatilities.

It's relevant to note here that the yield curve between 3-month and 10-year Treasury securities remains inverted. Historically, inversions of the yield curve, coupled with above-average stock valuations, have been regularly associated with negative subsequent market returns, on average. While that doesn't remove every speculative reason to accept market risk, it does add to the evidence suggesting that now is far from an ideal time to be placing capital at risk by holding unhedged investment positions.

The issue here is one of patience and discipline – if you believe that conditions favoring strong market returns at contained risks systematically emerge over the market cycle, and that we will visit those conditions repeatedly over time (and in the foreseeable future), then it's relatively comfortable to remain defensive in conditions that have been historically risky. On the other hand, if you mourn every percent that the market gains while hedged as “money forever lost,” then every missed advance will create pressure to get in, whatever the risk, whatever the price. You can easily guess which perspective I endorse.

In bonds, the Market Climate remained characterized by modestly unfavorable valuations and modestly favorable market action. Yields shot higher on Friday's employment report, partly because of the surprisingly low unemployment rate, but also because of continued evidence of wage inflation, which has been the most persistent of the various inflation series in recent months.

Despite the seemingly universal acceptance of the “Goldilocks” theme, the potential for further inflation pressures shouldn't be ruled out. For example, if we examine months where the yield curve was inverted, the ISM Purchasing Manager's Index dropped, and the 3-month T-bill yield rose (a combination which we saw last month, and have historically observed a small but not negligible 6% of the time), the CPI has typically shot nearly 1% higher in those same months, on average. Indeed, that small set of conditions (which are motivated by the monetary exchange equation) captures more than half the historical instances when inflation exploded higher in a given month. Not a forecast, just an observation.

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