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December 18, 2006

Performance Notes, Ouija Boards, Bollinger Bands, and Valuations

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

While our returns in the Strategic Growth Fund have been positive in recent months, they've clearly been uninspiring. Our risk-managed, value-conscious investment approach has been out of sync with the major indices. There are two factors at work here. First, since the market's May high, our stock selections haven't outperformed the S&P 500 or Russell 2000 (as they have generally done over longer spans). That certainly happens from time to time, but the effect feels magnified when it happens in a period where we're also hedged and the market moves higher over the short-term.

Looking at the stock market as a whole, there's been a sharp drop in the number of individual stocks outperforming the S&P 500, while at the same time, an increasing proportion of those outperforming stocks have poor quality ranks (as rated by S&P). That has raised a hurdle, though I expect only temporarily, for our value-conscious, bottom-up stock selection approach.

Second, over the past 10 weeks or so, the market has reflected overvalued, overbought, and overbullish conditions (a combination that has historically been associated with market returns below Treasury bill yields, on average – though not in every instance). During this period, we've been willing, even eager, to accept a material speculative exposure to market fluctuations (using call options), provided we observe a sufficient pullback to clear that overbought condition without major deterioration in internals. We haven't yet observed a pullback of even a few percent over these weeks.

While the Strategic Growth Fund does have enough call options presently to reduce our hedge by about 40% in the event of a substantial continued advance (they currently provide us with a 10-15% exposure to market fluctuations), that position still amounts to only about 1% of assets. In the event of a reasonable market pullback (say, a few percent), and assuming market internals were still intact at that point, I would be inclined to increase our call option position toward about 2% of assets, which would provide good exposure to any market advance that might begin from that lower base.

In any event, the upshot is that by adhering to a stock selection and hedging approach that has achieved strong returns with reasonable risk over the long-term, my efforts have achieved abysmally low returns in a rallying market over the short-term.

There are a few possible responses to this. One would be to abandon an approach that has a strong basis in both theory and evidence, and align ourselves with “what's working right now” – basically lifting our hedges and increasing our exposure to low-quality speculative stocks that are on the move. This is a recipe for disaster. You can't imagine my personal despair when a friend and client, pleased with his long-term performance but exasperated by my avoidance of the “glamour” tech stocks in late-1999, moved his retirement account to E*Trade, assuring me that he was only going to invest in “solid” techs like Lucent, Cisco, and Sun Microsystems. He was convinced that the tech boom had created a new economy. “We need to be a part of this.” I imagine he lost the bulk of his carefully built retirement wealth over the following two years.

A second response would be to close our ears and hum, adhering to our existing approach without any effort to adapt to possible changes in financial relationships. Again, that's not an acceptable approach. Especially since research is our strong suit.

So on any given day, what I'm actually doing is running variations of stock selection approaches on historical data – for example, testing the effectiveness of using operating P/E's, earnings momentum, etc. What I find is that the best performing approaches, even over the past decade, are those that emphasize normalized free cash flow, and are conscious of both valuations and market action. What I also find is that the versions that have performed best over the long-term are lagging this year, and that it's difficult to improve on our existing methodology. That's frustrating, but also somewhat comforting.

I also spend part of each week reading and listening to the arguments advanced by Wall Street analysts, and then going to the data to test them. These arguments include the Fed Model, the advocacy of price/operating earnings ratios, supposed links between earnings growth and market returns, arguments that the end of a Fed tightening cycle is quickly favorable for stocks, etc. Most of the current bullish arguments, unfortunately, are devoid of factual historical evidence. For example, while earnings growth and stock prices have a reasonable relationship over the long-run, the correlation between earnings growth and market changes on a year-to-year basis is roughly zero (actually slightly negative). And as I've noted before, when the price/peak earnings multiple for the S&P 500 has been 16 or higher (the current multiple is over 18), we find that the S&P 500 has experienced a loss, including dividends, averaging -6.5% over the 18-month period following the final hike of a Fed tightening cycle.

Ouija Boards

In both stock selection and market analysis, my essential requirement is that any approach I apply to actual Fund management has to have a mechanism – an understandable, theoretically sound reason why it should perform well over time (preferably based on the definition of a security as a stream of discounted cash flows), and it should achieve good returns with acceptable risk over a variety of independent sub-periods of history.

Martin Zweig once said that he would follow a Ouija board if it worked historically. I wouldn't. The reason is that if you're investing people's retirement wealth, college funds, or long-term savings, you'd better be sure you know exactly why what you are doing ought to work over the long-term. Because if you're just using a Ouija board, and the market starts going against you for some period of time, you're stuck – either you continue to follow something when you have no idea why it should work in the first place, or now you've got to find something else that works even though you don't understand why. In the end, you'll have neither confidence nor discipline.

It's exactly because our approach is grounded in both theory and historical experience that we can maintain confidence and discipline during admittedly uncomfortable periods like this. Over the full cycle, the market recognizes reasonably-valued stocks that throw off a reliable stream of cash to shareholders (especially those that exhibit enough investor sponsorship so that future cash flows aren't called into question on the basis of others' information). Over the full cycle, rich valuations revert to more appropriate levels. And even over the intermediate-term, overbought markets correct at least moderately.

Ultimately, it will be good to break out of this range. It may be a few weeks or even months, but meanwhile, my focus will continue to be research, and following a consistent set of actions that has historically achieved strong results. In most professions, outcomes tend to be closely related to effort and skill. While that's not generally true over the short-term for investment management, it still tends to be true over the full market cycle.

Notes on current market conditions

Jim Stack of Investech notes that the current bull market, at 4.2 years in duration, is unusually mature from a historical perspective. He notes, “Only 4 bull markets over the past 75 years had life spans which exceeded the current one.” Those included 1949 (which began at a price/peak earnings multiple of 6), 1974, 1982 (both which began at multiples of 7), and 1990 (which began at a multiple of 11 and ended in a hypervalued frenzy at nearly 34 times peak earnings). The current advance began at a multiple of 16, so even from the beginning we had less room for valuations to expand, compared with those unusually long bulls. And as noted below, valuations have now moved far higher (on the basis of a broad range of fundamentals) than current earnings would lead investors to believe.

Of course, that's part of the difficulty here. As long as investors perceive valuations to be acceptable, there is no compelling reason why the actual facts should get in their way over the short-term. That allows for the possibility that the current speculative blowoff will continue further. The implications for long-term returns remain daunting, but over the short-term, perception is reality.

Still, even from a short-term perspective, it makes little sense to “chase” the market here. Even any speculative positions investors contemplate would be best executed on a short-term market decline that clears the current overbought condition of the market.

Below, I've displayed a monthly chart of the S&P 500 going back to 1994. The chart also includes a set of “Bollinger Bands,” which form an envelope around the 20-month moving average.

Though I don't follow “chart patterns,” I do find that various tools like Bollinger bands can help to improve our trade execution in the day-to-day management of the Funds. They also help in maintaining investment discipline.

One of the immediate things to notice about Bollinger bands is that they don't provide very useful “buy” or “sell” points. Hitting the upper band, for example, is not a reliable signal that a security has peaked. Likewise, hitting the lower band provides no useful indication that a security has reached a trough. And though it seems from this chart like you could get some value from selling on a downside break of the moving average and buying an upside break, you tend to see a lot of “whipsaws” in practice. Also, the actual distance between the buy and sell points (based on the moving average signals) is not nearly as wide as the distance between the market's actual high and low.

So why bother with all of this? Well, there's a simple but important regularity that shouldn't be missed. Once the market has enjoyed a mature advance (not just an initial rally from a low, but an extended advance that has continued for some time, even if turns out to have even further to go), a move to the upper Bollinger band is almost invariably followed at a later date by a consolidation or a decline to a lower level. The same is generally true for individual securities, but the tendency is even stronger for markets as a whole.

Stated simply, it's almost never a good idea to buy the upper band in a mature market advance (which is where we are now). The market seldom “runs away” for long, and you generally have an equal or better entry opportunity later. That tendency is behind the relatively poor short-term market returns that emerge, on average, from the combination of overvalued, overbought, and overbullish market conditions. Again, the upper band is certainly not a reliable “sell signal” – it's just that investors rarely ought to “chase” a mature advance when the market is already at (or through) the band.

Even this simple feature of market dynamics can help investors to avoid being swept away and buying into an overextended advance. My impression is that this sort of restraint is especially important here.

On the subject of valuations, there is currently a substantial disconnect between current earnings and other fundamentals that until recent years have moved closely together. The most significant cause of this disconnect is the widening of profit margins of recent years, which is closely related to the sluggish growth of labor compensation. As the share of revenues going to labor compensation increases (which we're starting to observe not only here in the U.S. but also in Germany and elsewhere), profit margins are likely to narrow.

The following chart illustrates the current disconnect, and presents the market's price/revenue, price/book, price/dividend, and enterprise value/EBITDA multiples, scaled by their historical relationship to the S&P 500 price/peak earnings multiple.

While the current price/peak-earnings multiple is already at an elevated level above 18, what I'll call the “P/E equivalent” multiples on other fundamentals are: 21 on the basis of book values, nearly 23 on the basis of enterprise value/EBITDA (which factors in the increasing share of debt on corporate balance sheets), over 25 on the basis of revenues, and 29 on the basis of dividends (largely because dividend payout ratios remain relatively low even on the basis of normalized earnings).

Among these alternatives, my impression is that the “P/E equivalent” figure of just over 25, based on revenues, is the most accurate measure of “true” current valuations on the basis of normalized earnings. You can see from the chart why everybody loved EBITDA in the late 1990's, and why it's not so popular anymore. Wall Street analysts seem to pick the fundamental that gives them the lowest valuation to tout. Recently, a few analysts have even appeared on CNBC quoting metrics like “price to 2010 operating earnings.” Now there's a bag of wishes for sale.

I can't emphasize enough that net earnings, operating earnings, forward operating earnings, and even peak-earnings, all presently understate the market's valuation level, and are not reliable metrics here. P/E ratios formed on the basis of these earnings figures implicitly assume that current record profit margins will be maintained indefinitely. This is an enormously dangerous assumption.

Again, however, nothing prevents investors from driving the market higher over the short-term so long as Wall Street analysts propagate the same sort of ignorance that they encouraged in the late 1990's. In any event, further market gains on the hallucination that P/E multiples are “reasonable” will only make the long-term resolution worse. We're willing to accept a limited amount of call option exposure based on the current speculative mood of investors, but a larger speculative exposure is still best executed on a short-term pullback that clears the strenuously overbought condition of the market.

Keep in mind also that we don't require a return to “normal” or “undervalued” levels to warrant a substantially unhedged investment stance. We lifted 70% of our hedges in 2003 when valuations were still well above historical norms. But valuations, even on a price/peak-earnings basis, are now in the same range as the 1929, 1972, and 1987 peaks. Profit margins are at record levels. And we observe nothing close to the economic and capital-spending momentum we saw even during the late 1990's. We can't rule out this speculative blowoff continuing for somewhat longer, but one simply has to dispose of the majority of historical perspective in order to advocate an aggressive investment position here.

Meanwhile, the most unfavorable comparisons for a risk-managed investment approach are always when the market has moved from trough-to-peak in an already overvalued market. That's uncomfortable, but it's also expected from time-to-time. My main concern is that in managing your assets over the long-term, I don't entirely exasperate you over the short-term. I hope that these weekly comments are useful to that end.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations, and relatively favorable market action. The prevailing overvalued, overbought, and overbullish combination of conditions has historically been associated with subsequent market returns below Treasury bill yields, so while we hold about 1% of assets in call options as a modest speculative exposure to market fluctuations, a larger exposure closer to 2% continues to await a short-term pullback sufficient to “clear” that overbought condition. As I've noted above, that's not a particularly tall order to fill when the market is already well through the upper band in a mature advance.

In bonds, the Market Climate remained characterized by unfavorable valuations and relatively favorable market action. The Strategic Total Return Fund continues to carry a duration of just under 2 years, mostly in Treasury inflation protected securities, and about 20% of assets in precious metals shares, for which the Market Climate continues to be favorable at present.


Wishing you a Merry Christmas, with the happiness that comes from appreciating the great and also the small ways we've each been blessed. Wishing you also a bright, happy Hanukkah, and a New Year full of promise.

As for me, your trust is always among the greater of the blessings I count. Thank you for that. And to those of you I know personally, or who periodically send a thoughtful word, an interesting observation, or an article to share, I'm very grateful for your friendship.

Have a great holiday.

- John


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