February 12, 2007
Despite my fairly pointed concern about risks here, it's very important not to establish a specific forecast or time frame for the direction of the market. It is true that we currently observe a narrow set of conditions that has previously been followed by abrupt market declines in relatively short order, and I've felt a responsibility to wave my arms around to emphasize that risk in recent weeks. But I cannot emphasize enough that our current defensive position is not driven by the forecast of an abrupt market decline – it is based on a more general set of conditions under which the stock market has underperformed Treasury bills, on average.
We shouldn't be surprised by a deep market loss, and we need not rule out the possibility of a further advance. I try to avoid investment positions that rely on any specific short-term forecast. Instead, the strategy is to constantly align our investment position with the average return/risk profile that has emerged from various market conditions. Over the full market cycle, that strategy is generally more than enough to capture the market's overall gains, while maintaining a constrained level of risk.
As I remarked in my November 24, 2003 comment:
“If an investor consistently takes positions based on forecasts, and changes those positions only when the market proves those forecasts wrong, that investor's life will predictably be dominated by hope, uncertainty, disappointment, reaction and frustration. If an investor constantly takes positions by responding to opportunities and conditions as they develop, with equanimity to what will happen next, making a habit of purchasing favorable value or early strength, and a similar habit of selling overvalue and early weakness, that investor's life will most probably be dominated by a sense of peace and control. Though it is not obvious which investor will have better results, my own opinion on that should be fairly clear.”
Let's play a little game – it's called “Baron Rothschild,” who once said “I made my fortune by selling too early” (a comment also made by Bernard Baruch). It's a lot like various kids' games where you know something bad will happen but you don't know when. These include “Musical Chairs,” “Don't break the ice” (where you take turns hammering out little ice blocks hoping that you won't cause the whole surface to collapse), or “Kerplunk” (where a load of marbles rests on sticks that have to be removed one by one). My impression is that investors are playing this sort of game here.
Suppose that the dealer lays cards down, one after another. Each is an annual market return. At any time, you can call out “Baron Rothschild” and go to a defensive position, or you can gamble and get the entire market return the dealer shows next. The gain cards read, say, 15%, 20%, 25% and 30%. If you're defensive, you lag the market by 10% when the market return is a gain, but you get, say, 5% if the market return is a loss.
There is one -20% loss card. Once it appears, the game ends and everyone counts their dough, compounded.
It turns out that if the loss comes anytime before the 5th card, you're almost always ensured to beat or tie the dealer by immediately blurting out “Baron Rothschild” even before the first card is shown. For example,
20%, 20%, 20%, 5% beats 30%, 30%, 30%, -20%.
15%, 15%, 15%, 5% beats 25%, 25%, 25%, -20%.
20%, 10%, 5%, 5% beats 30%, 20%, 15%, -20%.
5%, 5%, 5%, 5% ties 15%, 15%, 15%, -20%.
You can easily prove to yourself that even for a six-year market cycle, you still generally win even if you call out “Baron Rothschild” after year two. It just doesn't pay to risk the big loss.
The point of this isn't that investors should always take a defensive stance - some market conditions are associated with very strong return/risk profiles that warrant substantial exposure to market fluctuations. The point is that the avoidance of sigificant losses is generally worth accepting even long periods of defensiveness. Because of the mathematics of compounding, large losses have a disproportionate effect on cumulative returns. Remember that historically, most bear markets have not averaged 20%, but approach 30% or more. A 30% loss takes an 80% gain and turns it into a 26% gain. It's difficult to recover from such losses, which is why the recent bull market has not even put the market ahead of Treasury bills since 2000 or even 1998. So again, the point is that the avoidance of significant losses is typically worthwhile even if, like Baron Rothschild, one is defensive "too soon."
With regard to present stock market conditions, the market currently faces rich valuations, unusual bullishness, overbought conditions, rising yield trends, and a market long overdue for such a correction. Given the average return/risk profile those conditions have historically produced, it makes sense to call out "Baron Rothschild" even if we allow for the possibility of a further advance, in this particular instance, before the market inevitably corrects.
Less than half of the typical bull market gain is retained by the end of the subsequent bear market. Once stocks become richly valued, the remaining gains achieved by the market are almost always purely speculative – they are generally erased over the remaining course of the market cycle. There are reasonably good tools, based on the quality of market action, that have historically allowed the capture of a substantial portion of those “speculative” gains. But once the market becomes not only richly valued, but sentiment becomes broadly bullish and stocks become overbought on a shorter-term basis, the return/risk profile of the market becomes unfavorable even for speculation.
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations, generally favorable market action on the basis of breadth and internals, and an overbought, overbullish condition that has historically combined with rich valuations to produce average market returns below Treasury bill yields.
At present, it's still possible that we could clear the current overbought, overbullish condition with a good market pullback, and provided that internals remain reasonably firm, we could very well have sufficient evidence to accept a moderate amount of speculative exposure to the market (most probably through the use of call options in order to retain downside protection, given rich valuation levels). In any event, however, we don't have such evidence now, and a defensive position remains appropriate.
In bonds, the Market Climate remains characterized by relatively neutral valuations and relatively neutral market action. Risk spreads for low-grade debt have become disturbingly thin here, so there's not currently much of a “flight to safety” that might otherwise restrain inflation pressures and benefit Treasury securities. Still, spreads can hardly go much lower, so the real question is not how far they will narrow, but how long the narrow spreads will continue. As I've frequently noted, an abrupt widening in credit spreads would be a good signal of oncoming risks for both the U.S. economy and the U.S. dollar. We don't have immediate evidence of such risks, but it also would not take much deterioration in market-based indicators to supply it - again, particularly if such deterioration is abrupt.
While the desirability of longer durations in Treasuries would increase on evidence of widening credit spreads, for now the most likely factor that would increase our durations would be a push toward 5% on the 10-year Treasury yield. Meanwhile, we took advantage of further strength in utility shares last week to finally reduce our exposure in this group in the Strategic Total Return Fund. Though I expect utility shares to be a frequent part of the Fund, valuations have become rich even in this group. Though they tend to have lower sensitivity to market fluctuations, utility shares often experience substantial losses in periods of general market weakness. In the context of other stock market risks, it's an appropriate time to take a more defensive stance in that group. The Fund continues to hold about 20% of assets in precious metals shares, for which the Market Climate continues to be favorable on our measures.
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