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December 11, 2006

Phase Three: The Speculative Blowoff

John P. Hussman, Ph.D.
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Charles H. Dow, who edited the Wall Street Journal a century ago, once observed “It is impossible to tell in advance the length of any primary movement, but the further it goes, the greater the reaction when it comes, hence the more certainty of being able to trade successfully on that reaction… The best way of reading the market is from the standpoint of values. To know values is to comprehend the meaning of movements in the market.”

Dow's successor at the Wall Street Journal was William P. Hamilton, and was also a brilliant observer of the market. Hamilton observed that bull markets generally occur in three phases. As Richard Russell summarizes: “Phase one is the rebound from the depressed conditions of the previous bear market. Here stocks return to known values. In the second and longest phase, shares advance in recognition of improving business and a rising economy. During the third phase they spurt skyward on the hopes and expectations of a continuing rosy future… The low-priced ‘cats and dogs' historically make great moves in this third phase…”

As another follower of Dow, Robert Rhea, once wrote: “the final stage is sometimes recognizable because people then buy stocks simply because they go up, and because other people are buying them.”

With the S&P 500 currently trading at nearly 18 times fresh record earnings, on record profit margins, it seems clear that the current bull market is well into its third phase. To anyone who examines more than one or two decades of market history, even a multiple of 18 is very rich by historical measures, and can't be reconciled simply by reference to interest rates or inflation.

On closer inspection, of course, valuations are even more hostile. Over the past three years, profit margins have widened to record levels, which has detached P/E ratios from other fundamental measures – such as price/revenue, price/dividend, and price/book ratios. The S&P 500 is currently about double its historical norms on those metrics. That isn't a forecast that stocks have to eliminate that valuation gap, but it certainly does suggest that stocks are priced to deliver unsatisfactory long-term returns from these prices.

It bears repeating that if profit margins were at normal levels – even on the basis of profit margins that prevailed during the 1990's (indeed, anytime prior to the past 3 years) – the price/earnings ratio of the S&P 500 would currently be nearly 25. Unless investors want to speculate on the notion of a “permanently high plateau” in profit margins, the stock market is strenuously overvalued at present. Neither current earnings nor “forward” earnings should be considered – in themselves – as anything close to robust or reliable metrics of value here.

“Known values”

Our own approach doesn't focus particularly on bull/bear distinctions, because the true state of the market is only observable in hindsight. Instead, our focus is on measurable, observable, objective, and historically testable metrics of valuation and market action.

That said, in hindsight, Hamilton 's three-phase view of bull markets has a reasonable amount of historical support. Generally speaking, the first phase of a bull market begins from valuation levels that are below “known values.” On average, historical bull markets have begun from price/peak-earnings ratios below 11 and generally below 9. A few began at multiples below 7, including the bull markets that began in 1974 and 1982, as well as many of the bull markets in the early 1900's.

Typically, the explosive first-year advance in a bull market has involved a recovery from those very depressed P/E multiples, to “known values” around 11-12 times earnings, on average. So “phase one” in Hamilton 's scheme has generally involved a recovery in valuations from levels that have been identifiably below historical norms. Even with bull runs that began at higher multiples, such as 11 times earnings at the 1990 low, it can still be said that at least part of the early advance represented a rebound toward historical norms of valuation.

Not so for the current bull market, however. As brutal as the market's decline was between 2000 and late 2002 – despite a loss in the S&P 500 of about half and a loss in the Nasdaq of over two-thirds its value – market valuations at the bear market trough never penetrated below historical norms.

To put the 2000 top into perspective, recall that during the late 1990's bull run, the market experienced a series of speculative blowoffs. First, “Buffett-type” large-cap stocks were heavily favored through about 1996, and stocks like Coca Cola traded at hefty premiums to historical norms. Next came the dot-com bubble, but even that was largely over by 1998, as it became clear that profits are generally not secure in an industry where it is costless to compete and customers have no particular loyalty. Though both of those blowoffs easily qualified as “stage three” advances, the tech-stock bubble from late-1998 through early 2000 was by far the most irresponsible in that even many professional analysts, who should have known better, lost all sense of valuation and history.

If the sort of psychosis we observed in 2000 is our new metric for what constitutes risk, and stocks are still safe (as many chirping analysts seem to imply) because we're not at that extreme yet, then investors are doomed to spend the future the way they've spent the past 8 years or so – with stocks going nowhere, and lagging risk-free T-bills over the long-term (albeit alternating between exciting gains and horrifying losses, or vice-versa, with nothing to show for the round-trip).

At present, stocks are dangerously beyond “known values,” unless the values observed during the late-1990's bubble are the ones investors really care to know.

Speculative blowoffs

Given the overwhelming historical evidence that profit margins normalize over time, long-term investors should build that expectation into the prices that they pay for stocks, which after all, are nothing but a claim on a stream of future cash flows. A market P/E of nearly 25, on the basis of normalized profit margins, doesn't allow any margin of safety.

Still, we have to recognize, as Richard Russell once wrote, that “it is not history, facts, or intelligence that guide most investors through the final phases of a bull market; it is hopes and wishes.”

On that basis, it's not clear that the current speculative blowoff is over, or doomed to end in short order, so long as there are dangling strands of hope. Though the Strategic Growth Fund is well-hedged, we continue to hold a moderate position in index call options (increasing that position after short-term weakness, and clipping it somewhat after short-term market strength). I expect that we'll maintain that position until deteriorating internal market action makes it clear that investors have become more skittish toward risk.

Meanwhile, it's essential to recognize where the market is in terms of valuations, and in the context of the full market cycle. To repeat Charles Dow, “To know values is to understand the meaning of movements in the market.”

Among the current signs that the market is engaged in a speculative blowoff, investment advisory bullishness is running near 60%, which Investors Intelligence notes is about the level where historical bull markets have ended. As for the “smart money,” corporate insiders are aggressively liquidating stock, at a rate of about 7 shares sold for each share purchased, according to recent figures from Vickers. Meanwhile, the new issues market is booming, and low-quality stocks (on the basis of S&P's quality rankings) have for months dominated an otherwise dwindling group of market leaders.

Though CNBC briefly seemed professional in the wake of the 2000-2002 market plunge, airing short conversational spots where the anchors emphasized journalistic responsibility, that tenor has now been replaced by carnival-barking shows like “Mad Money,” complete with its lightning round, featuring a shrill whine of irresponsible speculative “plays” backed by death-metal guitar music, and “Fast Money” promoted by spots that promise, for example, “Tonight, the boys get down and dirty with a hot commodity...” I wish I was making this up.

All of that said, keep in mind that even the knowledge that stocks are in a speculative blowoff isn't a very useful basis for short-term forecasts. Rather, it provides a general guidepost about the position of the market within the typical bull/bear cycle.

Overall, it's late in the game.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations, relatively favorable market action, and the combination of overbought and overbullish conditions. While the overvalued, overbought, overbullish combination has historically been associated with average market returns below Treasury bill yields, even a decline of a few percent would clear that condition. We do hold a modest position, just under 1% of assets, in index call options to allow for the possibility of a further advance without such a pullback, and I would expect to increase that position toward say, 2% of assets, on pullbacks of even moderate size.

In sum, valuations are rich, and it is unlikely that stocks will deliver satisfactory long-term returns from these levels. Meanwhile, market action is generally good, so there isn't much evidence that investors have much aversion to accepting market risk. So while the long-term danger to this market appears quite high, there isn't strong evidence that would allow a prediction of imminent market losses, beyond enough of a decline to clear the current overbought condition. We can't rule out deep market losses, and recognizing the potential for conditions to change quickly, we would certainly not abandon our defense against them, but my guess is that investors hoping for a near-term market plunge may be more likely to get a sideways trading range for a while, possibly with an upward bias, possibly with a downward one. A measurable deterioration of market internals (breadth, leadership, etc) would substantially increase the near-term risk of deep weakness. We just don't observe that yet.

In any event, our portfolio holdings have started to perform more characteristically, relative to the market, in recent weeks. Meanwhile, we're well hedged against major downside risk in the market, and we have a moderate call option position at extremely low premium cost (as a result of low implied volatilities here) that should allow us a moderate but not excessively speculative degree of participation in a further market advance should it occur.

In bonds, the Market Climate remained characterized by unfavorable valuations and moderately favorable market action. The level of yields and profile of the yield curve doesn't provide a compelling reason to take long-duration investment positions here. The Strategic Total Return Fund continues to carry a short-duration position of just under 2-years, mostly in Treasury Inflation Protected Securities, with just over 20% of assets in precious metals shares, where the Market Climate continues to be quite favorable on our measures.

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