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November 13, 2006

Low Yields

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

In a recent segment of National Public Radio's “Car Talk,” a guy called in with a Datsun that had over 200,000 miles on it. The base of the floorboard had long rusted away, and the accelerator pedal had detached from the vehicle. Not wanting to pay for a new floor plate to be welded in, the caller fitted a round pad of rubber to push down the accelerator mechanism, and glued it under the ball of his right shoe, which he wore at all times. The problem was that he was developing a limp…

There are times when you stop trying to get the last mile out of a car, squeeze the final bit of toothpaste out of the tube, or speculate for an extra few percent in an overvalued, overbought, overbullish market that has every likelihood of surrendering those gains over the full cycle, even if they materialize.

I don't hesitate to recognize that the quality of market action remains favorable here, which has historically been an indication that investors have no particular aversion to risk, and are in a speculative mood. More often than not, that has been associated with positive stock market returns, even when valuations have been elevated. The difficulty at present is that despite generally favorable market action, stocks are strenuously overbought, and advisory sentiment shows very little bearishness (just 26% bears, according to the latest Investors Intelligence figures). Historically, this has defined what I call a “sub-climate” where stocks have typically underperformed Treasury bills, on average, until the overbought or overbullish condition (generally both) has cleared.

In some cases, a decline that “clears” the overbought condition is also accompanied by enough internal deterioration in the quality of market action to shift the Market Climate to a fully negative condition. So several historical “overvalued, overbought, overbullish” conditions turned out in hindsight to be market tops. But presently, we don't have that evidence. What we have is an overvalued, overbought, overbullish market, with prospects of slower economic growth, narrowing profit margins, and dollar weakness, and yet, also with market action favorable enough to suggest a speculative mood among investors.

In short, there's no rush to take market risk here given the overextended condition of the market, but if the market declines enough to clear this condition without a great deal of internal damage, we will have to allow for a return to new highs. Until the quality of market action deteriorates enough to suggest a fresh “skittishness” on the part of investors, we can't become too eager for the market to complete its cycle by achieving more attractive levels of valuation right away.

For the Strategic Growth Fund, that means that we currently have less than 1% of assets invested in call options, but that we're willing to scale that position to about 2% of assets on a reasonable market correction. Such a position would allow the Fund to participate in as much as 40-50% of the market's fluctuations, but without sacrificing much downside coverage. Our present call position gives us “directional” exposure in the event the recent market advance pushes even further (the low implied volatilities in the options market make this sort of coverage fairly cheap in terms of potential time decay).

As I've frequently noted, current valuations are already rich enough to conclude that the market has very little “investment” merit. Stocks are currently not priced to deliver satisfactory long-term returns, nor are they likely to achieve further gains that would be retained over the full market cycle. So any market risk we accept here is “speculative.” While I do believe that the quality of market action is a useful guide to establishing and removing speculative positions, and that such positions can partially relieve the discomfort of standing aside in richly valued markets that are continuing higher for a while, I don't believe that large speculative exposures are necessary to long-term investment success.

Aside from that 1-2% potential exposure in call option positions to provide speculative exposure, the Strategic Growth Fund remains fully hedged.

Low yields

In reviewing investment conditions this week, I'm struck by the general insufficiency of yields across the investment landscape. In Treasuries, the yield curve is inverted, with 10-year yields below 3-month Treasury yields, which itself has typically been unfavorable for stocks, and much more so when the general level of yields has been depressed.

While it's true that declining yields have generally been favorable for stocks, investors should make a strong distinction between “declining” (an indication of trend) and “low” (an indication of level).

I can't emphasize enough that the most hostile periods for stocks (as well as bonds) have been those where yield levels have started at low levels and have been pressed higher. While it's true that you can squeeze a reasonable capital gain out of a low-yielding market, by pushing yields even lower, that's definitely not where you find sustained gains, or gains that are typically retained over the full market cycle.

Beyond the comments on the “Fed Model” I've made in recent weeks, it also bears repeating that when the overall level of yields has been low, a “buy signal” on the Fed Model (meaning that 10-year Treasury yields are lower than the forward operating earnings yield on the S&P 500) has not been a reliable buy signal for stocks at all, but has often been a great sell signal on bonds.

As for the universally-known fact that slower economic growth means slower inflation, I would submit that it's not a fact at all.

The chart above shows data from 1962 to the present. The inverse relationship between economic growth and inflation (i.e. higher economic growth implies lower inflation) is not just a feature of historical data – it's also perfectly consistent with economic theory (it is an identity that price inflation can be written as %P = %M + %V - %Y, where M is money, V is velocity, and Y is real output). In other words, holding money and velocity constant, inflation and economic growth should have a negative relationship, with a slope of -1. As I've noted before, it can be useful to broaden the definition of “M” to include all government liabilities, whether they are issued by the Fed or the Treasury.

Basically, you get inflation when there is a lot of growth in government liabilities (high %M) and investors are not willing to hold them (high %V – essentially, velocity is high when investors treat government liabilities like a hot potato). We may in fact observe inflationary pressures near the tail of an economic boom, but that's generally because output can't grow fast enough to satisfy demand. Faster output growth alleviates inflationary pressures.

Likewise, you get an easing of inflation when there is restrained growth in government liabilities, or investors are very eager to hold those liabilities. You see that a lot during periods of credit default and bankruptcy, because investors rush for the safety of government bonds and currency. Even during these periods, less availability of goods (low %Y) serves to increase inflationary pressure.

That's why interest rates often lead inflation (rather than simply following it). Higher interest rates are a signal of weak demand for government liabilities generally. Likewise, weakness in the foreign exchange value of the U.S. dollar can also be an indication of weak demand for U.S. government liabilities.

Presently, the inflation picture is mixed, but it's not at all clear that inflation has become a non-issue. On the side of low inflation, intermediate-term interest rates have backed off in recent months, suggesting decent demand for government liabilities. However, T-bill yields are still holding near their highs. The inverted yield curve and the weakness in the U.S. dollar in recent sessions are not favorable toward the low inflation case. The year-over-year rate of core inflation has also been increasing without interruption. Overall, it's difficult to conclude that inflation concerns have become irrelevant.

Suffice it to say that the stock and bond markets currently reflect very depressed yield levels, and that the case for lower yields is not as clear as is widely argued. While we can't rule out the potential for still lower yields, it's increasingly important to remember that the most hostile periods for stocks and bonds have typically been associated with upward pressure on yields from relatively low starting levels.

Market Climate

As of last week, the Market Climate in stocks was characterized by unfavorable valuations but favorable market action. The overvalued, overbought, and overbullish character of the market has generally not been favorable for short-term returns, as stocks have generally underperformed Treasury bills under those conditions. So a market decline to “clear” this overbought condition would be a reasonable point at which to add modest speculative positions, so long as market internals don't deteriorate measurably. For now, the Strategic Growth Fund remains fully hedged, with a small position in index call options, less than 1% of assets, on the basis of generally favorable market action.

In bonds, the Strategic Total Return Fund continues to carry about a 2-year duration, mostly in Treasury Inflation Protected Securities, as well as a roughly 20% exposure in precious metals shares.

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