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April 9, 2007

Investors Need Not Be Bearish to Hedge Risk

John P. Hussman, Ph.D.
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While the S&P 500 has gained just 4% from its March lows on a weekly closing basis, it is clear that investors and market analysts now view the recent market correction as ancient history. The Investment Intelligence figures on advisory sentiment have shifted clearly to the bullish camp, with 50.6% of advisors bullish and 26.3% bearish.

Meanwhile, valuations remain rich, the yield curve remains inverted (10 year vs. 3-month Treasury yields) and interest rates are now in fairly uniformly uptrends. I cannot stress enough that the most violent market declines have always emerged from conditions of rich valuations, elevated bullishness, overbought price trends, and upward pressures on interest rates. That doesn't mean that major losses must by necessity follow present conditions, but in the face of the historical tendency for deep losses to emerge in situations like this, it would be unwise to establish an investment position that relies on continued market strength.

On the bright side, Friday's employment figures were positive, and the wage figure was moderate. That's about the best that can be said about monthly figures that are volatile and constantly the subject of large revisions. On the broader evidence, any favorable economic implications of Friday's report continue to be outweighed by unfavorable inflation implications of what the Fed refers to as “the high level of resource utilization.”

Specifically, it's notable that when the yield curve has been inverted and factory utilization has been at 82% or higher (as it is today), the rate of core CPI inflation has accelerated to about double the historical average. While the actual inflation rate in those instances has averaged nearly 8% on an annualized basis, we needn't observe anything above a 2% rate in order to maintain the Fed's view that core inflation remains “uncomfortably high.”

Though Wall Street's knee jerk reaction may be to hail the employment report as hope for a stable housing market and higher earnings, the report does little to alleviate the poor condition of household balance sheets, and nothing to reduce interest burdens. I suspect this reality will set in soon enough, even if the market responds positively at first.

On the earnings front, profit margins remain unusually elevated, unit labor costs continue to rise, and S&P 500 earnings are again pushing against the 6% growth trendline that has connected past earnings peaks as far back as one cares to look. Again, the employment report does little to alter the outlook for profit margin pressures in the months ahead.

[Despite the frequently repeated delusion that annual earnings growth of “10% or so” is the norm, history doesn't provide any evidence of peak-to-peak growth faster than 6% over the long-term. Nor does the history of dividends or revenues. Indeed, the fastest 30-year growth rate for such fundamentals over the past century has been only 6.4%, which reflected a long trough-to-peak growth period. Measured from peak-to-peak across economic cycles, growth rates have been remarkably well constrained at 6% annually.]

As earnings pre-announcements begin this week, continue to listen for comments relating to profit margins. Analysts are already slashing expectations for earnings growth. As the New York Times noted last week, analyst expectations at the beginning of 2007 were for first-quarter earnings to post year-over-year growth of 8.7%. Current estimates have been cut to an expectation of just 3.3% growth. Second quarter growth is now projected to be just 3.5% year-over-year, with full-year growth estimates down to 6.3% (effectively building rapid growth expectations into the second half to compensate). If investors no longer have hopes for a near-term easing from the Fed, nor hopes for rapid earnings growth, the only remaining notion is the belief that stocks are appropriately priced on the basis of “forward operating earnings.” As I've emphasized in recent comments, this belief is fiction.

In all, investors continue to look for hopeful signs on which to base a speculative outlook. We can't rule out the possibility that they will continue to speculate on the basis of one report or another, but we also have to consider the larger set of conditions, including rich valuations threatened by upward interest rate and inflation pressures, high bullishness and overbought price trends; elevated profit margins threatened by rising unit labor costs; and high capacity utilization and an inverted yield curve, among other inflationary factors.

Again, we aren't relying on or predicting a major decline in the stock market, but conditions are such that we certainly should not rule one out. The gap between current prices and reliable valuations (based on normalized earnings and other fundamentals) is far wider than investors seem to appreciate. For now, as always, we prefer not to base our investment positions on near-term forecasts, but instead have aligned our position with the prevailing Market Climate, and are focused on disciplined stock selection in order to maintain favorable valuation and market action among our individual stock holdings.

Market Climate

As of last week, the Market Climate held us to a fully hedged position in the Strategic Growth Fund, reflecting unfavorable valuations, moderately constructive price trends, and a combination of overvalued, overbought, overbullish conditions that has historically produced stock returns below Treasury bill yields, on average.

As usual, “on average” is the operative phrase. You can think of each Market Climate we identify as a probability distribution (picture a bell curve) that includes both positive and negative outcomes. Based on a given set of observable conditions, we associate those conditions with one of those bell curves. And they vary quite a bit in their average return/risk tradeoffs. When stocks are undervalued, market internals are showing divergent strength, and interest rate and inflation pressures are generally downward, the average return tends to be very high, with a fairly narrow range of outcomes, producing a spectacular return/risk profile.

In contrast, when stocks are richly valued, market internals are deteriorating, and interest rate and inflation pressures are generally upward, the average return is negative, with a wide range of outcomes, but mostly because of a “negative skew” that reflects the fact that most crashes have emerged from those conditions. We're not quite at that point, because market internals have not broken down persistently, but again, we're already in a condition where stocks have typically lagged T-bills on average.

So identifying a particular Market Climate gives us an idea of the average return, the range of returns, and the “skew” of the tails. But – and this is important – it does not tell us whether the next draw from the bell curve will be a positive return or a negative one. That's why I constantly emphasize that our positions are not based on forecasts or scenarios. Every Climate we identify represents a “bin” or “bell” or “hat” or “distribution” of returns that can be both positive or negative. It's just that the average return, the range of return, and the outliers (or “tails”) are different depending on the Climate we identify.

Presently, again, we're in a set of conditions that has not produced an attractive return/risk tradeoff on average. It's not a situation where we have to forecast or rely on market declines, though we shouldn't rule them out. It's just a situation where you would not do well, on average, in a repeated game.

In bonds, the Market Climate as of last week was characterized by unfavorable valuations (though slightly improved on Friday) and unfavorable market action in the form of upward pressures on both interest rates and inflation. The Strategic Total Return Fund continues to carry a short 2-year duration, mostly in TIPS, with just over 20% of assets in precious metals shares, where the Market Climate continues to be favorable on our measures.

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