June 4, 2007
Henny Youngman used to tell a story about a guy who hears a little voice in his head singing “Go to Las Vegas .” So the guy immediately turns his car around and heads for Las Vegas . The voice says “Go to the roulette table.” The guy goes to the roulette table. The voice says “Put $10,000 down on red.” The guy puts $10,000 down on red.
He loses. The voice says, “Hey, how ‘bout that?”
Investors are hearing a thousand little voices here telling them to “ride the bull,” that stocks have a “floor” under them, and that valuations are cheap. Whatever risks investors choose to take, they would do well to recognize that if those risks go terribly wrong, most of those little voices will be passive observers with nothing to say but “Hey, how ‘bout that.” You should evaluate every argument, bullish or bearish, based on the quality of the evidence and the credibility of the source.
For our part, we aren't taking significant risks here – bullish or bearish. Essentially, my investment view is that the market is in a speculative blowoff that may continue to grind marginally higher, but is also vulnerable to abrupt, possibly spectacular losses. Overall, based on prevailing conditions, market risk is not worth taking (as usual, nearly every dollar of my net worth is invested in the Hussman Funds, so I am far from a passive observer).
Currently, the Strategic Growth Fund is fully hedged – not relying on a continued advance, nor relying on a plunge (though the current overvalued, overbought, overbullish, rising-yield conditions strongly suggest that a market plunge shouldn't be ruled out). Our investment position does carry the expectation that our favored stocks will outperform the indices we use to hedge, but the amount of “basis risk” we are taking is moderate. We also have a fraction of 1% of assets allocated to a “staggered strike” hedge that provides us with somewhat better downside protection at the cost of lower “implied interest” on that hedge.
The Strategic Growth Fund is intended to outperform the long-term returns of the S&P 500 over the full cycle, with returns generally above Treasury bill yields (regardless of market direction) during periods when the Fund is hedged. Including reinvested distributions, the Strategic Growth Fund is only about 2% from its all-time high, and has substantially outperformed the S&P 500 and Russell 2000 over the full market cycle from the 2000 high to the recent high, with far smaller drawdowns. Still, recent returns have been flat, and are short of what I would generally expect when the Fund is hedged. That has primarily been the result of a preference by investors for low-quality and cyclical stocks – characteristics that typically don't provide durable outperformance over the full cycle, but have been on a tear of late.
Meanwhile, it's important to recognize how quickly a market decline can move a hedged investment from a lagging to a leading position. For example, suppose that the market is up 60% over a period of several years, and a hedged position is up 40%. Even though the hedged performance lags the market by 20%, it takes only a 12.5% market retreat (1.4/1.6-1) to bring the two back to equality assuming flat hedged performance (the required decline is less if the hedged position earns a positive return, and more if the hedged position participates in the market decline). Though it's certainly frustrating to see the market making continued marginal new highs while we are hedged, investors should recognize that in similar conditions, the subsequent decline from an overbought peak has abruptly erased weeks or months of market progress in a matter of days.
As usual, that's not a forecast. We are not “betting” on a decline, nor are we positioned in a way that would generate predictable losses over time, even if the market continues higher. Our hedged position is not based on a forecast that the bull market is over or that a bear market is about to start. Rather, we are fully hedged based on the far more general consideration that stocks have typically lagged Treasury bills on average given conditions similar to the present. Even if long-term conditions have changed, and the economy is in a new era of globalization, and liquidity is flowing from every corner, and the bull market is going to last forever, lifting our hedges here would require us to believe that even the normal short-term and intermediate-term dynamics of the market have been eliminated. We would have to believe that not even a consolidation or a correction can be expected anymore – even from a long-uncorrected advance in extremely overbought, overbullish conditions compounded by rising interest rate trends.
That assumption comes in far too large a crock to swallow whole.
Again, stocks have historically lagged Treasury bills, on average, from the point that conditions have reflected rich valuations, high bullishness, and overbought short-term trends, until the point that those conditions have been cleared by at least a moderate market decline. This has not been true of every single instance, but is certainly true on average. Moreover, when such conditions have been compounded by rising interest rate trends, the typical returns have been clearly negative, and on several occasions, spectacularly so.
It's that dynamic that drives our fully hedged position here – not the belief that the economy is on the verge of recession, or that the mortgage market will implode, or that international markets will collapse. Though it's unlikely that we would establish more than about a 40% exposure to market fluctuations in this range of valuations, even on an oversold short-term decline with internals still favorable, I am certainly willing to accept some amount of market exposure if the overall set of conditions becomes less hostile.
There are clearly points where the market has speculative merit on the basis of broad market action and favorable internals, even if valuations don't provide much investment merit. But there are also points where investment merit is clearly absent and speculative trends become strikingly overextended. Then the only reason for speculating is that investors are speculating. On average, those periods turn out badly.
Henny Youngman used to tell another story - this guy tells his broker to buy a stock at $5. “Buy as much as you can.” The next day the broker calls back and says the stock is at 6. The guy says “keep buying.” The next day the broker says “the stock is at 7, do you want to sell?” The guy says “keep buying.” Finally, the guy calls his broker and says, “Sell everything at 9.” The broker says “to who?”
A few additional comments regarding the “Fed Model.” As I've noted frequently, the main argument for the Fed Model is based on a few “spikes” in the gap between earnings yields and 10-year bond yields since 1980 – mainly two “bearish” readings in 1987 and 2000, and a “bullish” one in 2003. All of these were driven more by transitory interest rate action than by equity valuation. Here's the standard chart, where high readings are interpreted as “overvalued” and low readings are interpreted as “undervalued.”
Now, it's true that upward trends in interest rates tend to be hostile for stocks, especially at low yield levels, so a sudden widening in the yield gap can be important. Conversely, falling trends in interest rates tend to be supportive for stocks, though during the most recent bear market, you would still have lost about a third of your money between the point that the Fed Model signaled that stocks were cheap and the point where the bear market hit its low, despite falling interest rates.
The real problem is that it's simply not true that the level of interest rates has a reliable relationship to the level of stock yields, and it's on that misconception that Fed Model adherents will ultimately have their heads handed to them. They're relying on that levels argument to conclude that stocks are reasonably valued here. As a striking example, note that the 1982 low was considered by the Fed Model to be only about 15% undervalued, despite the fact that it was followed by 20% annual total returns to investors – not just over the next year, not just over the next decade (which had nothing to do with the bubble), but over the next 18 years. And despite the fact that the S&P 500 P/E was just 7 then and is 18.4 times record earnings on record profit margins now (and over 25 times earnings on normalized margins), the model suggests that stocks are “cheaper” today than they were in 1982. I'm sorry, but that's insane.
The fact is that stocks began the 1980's at extremely cheap valuations and moved to profoundly elevated ones by the late 1990's (we can support this observation by noting that stocks achieved spectacular returns from the early 1980 levels but have lagged Treasury bill returns during the past 8 years). Most of the change in earnings yields since 1980 has reflected a major change in the long-term attractiveness of stocks, not simply a “fair value” relationship with interest rates. By loading the entire explanation for the change in earnings yields on the 10-year Treasury yield, the Fed Model grossly overstates the importance of interest rates on stock valuations.
The model also finds the market cheaper in 1993 – after a 70% advance – than it was in 1990, which was the major trough in that decade. Pretty pictures aside, except at the occasional “spikes,” the model's implications have had no relationship to either short-term or long-term returns.
Moreover, if we examine data prior to 1980*, the picture turns ridiculous, suggesting that stocks were never overvalued prior to 1987, including in 1972, just before they lost half their value. If one wants to believe the Fed Model, it's worth noting that the market's current valuation is about the same as at the 1929 peak. A picture is worth a thousand words, but only if you've got the whole picture.
As always, the proof of the pudding is in the eating, particularly over the complete market cycle. As I detailed in prior weekly comments, “correcting” P/E ratios for the level of 10-year Treasury yields based on an assumed one-to-one yield relationship actually destroys the ability to explain subsequent intermediate and long-term returns, while the raw price/peak-earnings ratio retains significant power for both.
All of that said, the present “undervalued” readings from the Fed Model may unfortunately be a bullish catalyst for a while longer, but only because there are enough users of the model who assume it is valid (the first to abandon it will ultimately outperform the last who abandon it, but it may take time). None of that will change the fact that stocks are priced to deliver disappointing long-term returns here, but it may very well extend the period of overvaluation. Still, even if we accept the possibility of a more extended advance, the combination of overvalued, overbought, overbullish, rising yield conditions suggests that speculating on the speculation of others would be dangerous here.
As of last week, the Market Climate for stocks was characterized by unusually unfavorable valuations, positive market action on the basis of broad price trends, but also a combination of overvalued, overbought, overbullish and rising-yield conditions that has generally been followed not only by returns below Treasury bill yields, on average, but typically by deep and abrupt market losses. That tendency, however, has generally not provided other forewarning – stocks have tended to achieve successive marginal new highs until an abrupt correction has emerged that eliminates weeks or months of progress.
That's not a certain outcome, but the average return/risk profile is sufficiently poor to warrant a fully hedged stance, and even enough to warrant a “staggered” strike position to improve our defense against market weakness. Again, this is not a “bearish” or “short” position, but essentially one that provides strong downside protection without exposing us to expected losses should the market continue higher. The cost of that additional defense is a reduction in the implied interest we would otherwise earn on our hedges, but again, we are not in a position that I would expect to experience predictable losses over time even if the market continues higher without any correction at all.
In bonds, the Market Climate last week was characterized by relatively neutral valuations and unfavorable market action. Although bond yields are not yet attractive enough to warrant extending our durations, they are getting closer to that point, so it is likely that the Strategic Total Return Fund will gradually establish a longer duration if yields rise considerably higher. At present, the Fund continues to carry a duration of about 2 years, mostly in TIPS, with about 20% of assets in precious metals shares, where the Market Climate remains favorable on our measures.
* Although "forward operating earnings" didn't exist prior to about 1980 (which is one of the reasons the Fed Model endures, since the average observer has no idea how badly its assumptions perform historically), we know that forward operating earnings can be closely approximated by by a markup over peak earnings to-date.
New from Bill Hester: Private Equity and Market Valuation
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