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April 23, 2007

Foxes Minding the Henhouse

John P. Hussman, Ph.D.
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One of the disturbing features of the final advance to the 2000 bubble peak was that it involved much more than just uninformed speculation by individual investors. As those of you who've known me since then will remember, I was troubled by the fact that professional advisors and Wall Street analysts – people who I was convinced had both the duty and capacity to know better – had also abandoned their grip on the basic fundamentals of investing.

The inevitable losses that followed – half the value of the S&P 500 and over three-quarters of the value of the Nasdaq, did prompt a modest respect for those principles among investors. The 2002-2003 lows never actually reached even average valuations, much less historical medians, but we did observe enough value based on normalized fundamentals and improved market action to remove most of our hedges in early 2003.

That brief period of value is long gone. Investors never actually re-learned the lesson that valuation matters, partly because the lesson was overshadowed by the (not-unrelated) scandals at Enron, Worldcom, and other companies. Indeed, the main lesson that investors seemed to take away from the whole experience was that the guys at Enron were crooks. Beyond that, nothing. And now, even the memory of Enron's maneuverings has been lost.

Case in point: Following the Enron blow-up, the Financial Accounting Standards Board banned an accounting practice that Enron had used to book expected future profits as earnings, immediately, at very the moment it made an investment. In February of this year, the FASB effectively reversed itself in a rule that re-admitted the practice.

Perhaps not surprisingly, the buyout firm Blackstone Group has now filed for an initial public offering of shares. Blackstone is expected to apply the new accounting rule to immediately book the management and performance fees it expects to receive on long-term deals involving private companies, to which it may also apply its own fair value estimates. As the Wall Street Journal quoted Jack Ciesielski of the Accounting Analyst's Observer, “This is a black box if there ever was one.”

Meanwhile, leveraged buyouts continue to be a source of excitement in the market. These are essentially being driven by the willingness of investors to buy risky debt without demanding any premium for the risk. Much of this may not be exactly intentional – what investors are really doing is handing their money to various hedge funds, thinking that they'll earn good returns and leaving it at that. The hedge funds then take the dough and lend it to other groups that need to finance leveraged buyouts, many of which make very little sense from a valuation standpoint. The valuation ratios (most commonly enterprise value / EBITDA) on such deals have never been higher. And if the deals go belly-up, well, it's other people's money.

And talk about other people's money. Has anybody noticed that the favorite leveraged buyout targets are increasingly ones tied to governments that can't afford to let them fail? Why do you think they're going after BCE, the largest telephone company in Canada , or Sallie Mae, the source of countless student loans that have at least the implicit backing of the U.S. government? This is a recipe for government bailouts. Don't investors realize how much of this LBO activity is implicitly being done on somebody else's dime?

Of course, it's still on the issue of “operating earnings” and the “Fed Model” where the complicity and irresponsibility of Wall Street analysts is most apparent. What's happened over the past several years is that the whole definition of “earnings” has been changed from what it has been historically, while a simplistic ratio – “forward operating earnings yield compared with the 10-year Treasury yield” has taken the place of all serious valuation effort.

On the applicability of these, let me just repeat that data on “operating earnings” go back only to about 1980. They are not even defined under generally accepted accounting principles. Since that time, the market's P/E on “forward operating earnings” has generally been substantially lower than the price/peak earnings ratio based on the highest level of trailing net earnings to-date. Now, the price/peak earnings ratio, which can be calculated back as far as one likes, has historically had an average of only about 15, a median of about 11, and has averaged only about 9 when earnings have been at their long-term 6% growth trendline (as they are currently). Given that the P/E on forward operating earnings has been about 10-20% lower than the price/peak version throughout its history, the corresponding historical norms for price/forward operating earnings would be about: average 13 and median 9.5. At points where earnings have grown to meet the long-term 6% growth trendline that has connected past earnings peaks (earnings are currently at that trendline again), the typical price/forward operating earnings multiple would most likely have been less than 9.

It's simply absurd to think that a multiple of 16 times forward operating earnings on record forward earnings on record profit margins is “about right.”

Meanwhile, the loose one-to-one relationship between the forward operating yield and the 10-year Treasury yield is largely an artifact of stocks having been deeply undervalued in the early 1980's and profoundly overvalued by the late 1990's. So yes, interest rates fell during that period, but stock yields fell far more than can be attributed to the decline in interest rates alone. To attribute the entire decline in stock yields to interest rates as if it is a “fair value” relationship is to introduce a profound “omitted variables” bias into the whole analysis, which is exactly what the Fed Model does.

One can quickly validate that criticism (and invalidate the Fed Model) by noting that there is nothing close to a one-to-one relationship between interest rates and earnings yields – normalized or not – in historical data prior to 1980.

In short, the valuation tools upon which Wall Street analysts increasingly base their analysis are, in fact, pure unadulterated garbage. Over time, investors will discover this along with a good deal of pain.

Ultimately, stocks are a claim on a stream of payments that will be delivered to investors over time, and investors re-price stocks when they realize those payments aren't coming. The unfortunate aspect of the “operating earnings” culture is that it deceives investors to believe that they have larger claims to future payments than they actually have.

Over the short-term, unfortunately, there is no assurance that investors or analysts will quickly recognize that this market is trading on the basis of false premises about earnings and valuation (though my impression is that those who wake up based on reasoned argument and evidence will be better off than those who wake up based on investment losses). Until then, valuations may remain rich for a while longer.

Still, even in an environment where the market trades in a range of high valuation, it is appropriate to hedge exposure to risk at points where conditions are overvalued, overbought, and overbullish, and to establish more constructive exposure when conditions are overvalued, but oversold on a short-term basis (provided that the broad tone of market action still indicates a general willingness of investors to speculate). That's essentially our approach here. We need not assume that stocks will become reasonably valued anytime soon, but even if one is willing to accept some amount of speculative risk in an overvalued market, there's no need to accept undue risk at clearly overbought and overbullish points.

Marginal Highs, Hazardous Ovoboby

Amidst the ebullient coverage on CNBC of a 7-year market high (unlikely banner headline: “Stocks have gone nowhere for 7 years!”), we should remember that this is once again a very marginal new high. The S&P 500 and the Strategic Growth Fund have both gained a bit less than 2% since the late February market peak (though with differing levels of volatility), while the Russell 2000 is roughly unchanged. Despite the appearance of a market that's “running away” on the upside, we're really simply back to the same overvalued, overbought, overbullish condition that the market registered before the late-February plunge.

To an insignificant statistical difference (e.g. advisory bulls are 52.7% rather than 53%, and the comparison between current interest rates and those 6 months ago varies slightly from day-to-day), we are once again at a condition that I've called “Hazardous Ovoboby” – overvalued, overbought, overbullish, yields rising. It has historically made sense to hedge against market fluctuations based on much less restrictive definitions of market conditions, but at present, the market is in a set of conditions that has almost invariably been followed by deep and abrupt losses, though often only after a further marginal advance over a small number of trading sessions. Not a forecast, as usual, but the risk should not be taken lightly.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations, positive market action on the basis of price trends, but also a combination of overvalued, overbought, overbullish conditions that has generally resulted in stock returns below Treasury bill yields. At present, the market lacks both investment merit and speculative merit, so the Strategic Growth Fund is fully hedged. In addition, based on the relatively unusual combination of overbought, overbullish conditions, inflation pressures, and the like, I once again staggered our put option strikes, which results in a lower “implied interest rate” earned on our hedges, in return for tighter protection in the event of an abrupt market selloff.

As usual, the performance of our stocks relative to the major indices tends to drive day-to-day fluctuations in Fund value when we are hedged, but that differential has also been our primary source of return over time. Meanwhile, though the Fund is tightly hedged, our long put, short call option combinations are established so that only one strike is in-the-money when they are initiated, so we would not expect to experience a sustained loss in value if the market were to advance substantially (which I view as unlikely, but which we also should not rule out).

In bonds, the Market Climate continued to be characterized by unfavorable valuations and unfavorable market action, holding the Strategic Total Return Fund to a short 2-year duration, mostly in Treasury inflation protected securities. The Fund continues to carry slightly over 20% of assets in precious metals shares, where the Market Climate continues to be quite favorable on our measures.

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