June 11, 2007
Straight to comments regarding market conditions – last week's decline did a great deal of internal damage among interest-sensitive securities, breadth, and other factors related to our measures of investor risk preferences. For several months, our primary reason for maintaining a defensive stance has been a combination of overvalued, overbought and overbullish conditions. This combination has historically been associated with average stock market returns below Treasury bill yields between the point of onset and the point where those conditions have been cleared, and that tendency has been evident even during periods when market action has otherwise appeared favorable.
More recently, rising interest rate trends have made the current set of conditions much more pointed, putting the current market environment within a small subset of historical instances that have generally been followed by deep and importantly – abrupt – market losses. While my use of the term “ovoboby” for this overvalued, overbought, overbullish, yields-rising combination may be casual, the potential risks are quite serious.
I've noted frequently that if the market can clear that set of conditions without a great deal of internal damage, it will be reasonable to remove a portion of our hedges, in the probable range of 20-35%, leaving the Strategic Growth Fund still largely hedged, but also accepting a moderate “speculative exposure” to market fluctuations – despite rich valuations. Most likely, we would establish that exposure using in-the-money call options, leaving our put option defenses against any steep or abrupt further market weakness in place.
The market is currently in an unusual position – On one hand, I expect that a decline of just 2-3% further should be enough to “clear” our measures of “overbought” and “overbullish” conditions. It would not come anywhere close to relieving the rich valuations of this market, but it is very important to recognize that it has historically been reasonable, with acceptable risk, to assume some amount of speculative exposure even in richly valued markets – provided that the overall quality of market action has indicated a continued preference of investors for risk. We base that evaluation on a variety of factors such as price/volume behavior, breadth across individual stocks and industry groups, interest rate trends, credit spreads, and other measures.
On the other hand, the damage we're observing in precisely those measures of market action would be compounded even by a 2-3% market decline, most probably enough to remove even the speculative basis for accepting market risk here.
We need not attempt to forecast which outcome will prevail. At present, the existing overvalued, overbought, overbullish, yields-rising conditions are sufficient to hold us to a defensive position. If we can clear these conditions with a moderate further decline in the major indices without a significant further deterioration in market internals (particularly in market breadth or interest-sensitive securities), that “positive divergence” from internals would support a moderate speculative exposure to market fluctuations. Again, our potential “speculative” exposure would be in the range of perhaps 20-35%, primarily using call options, while maintaining put protection on the Fund's holdings. That would allow reasonable participation in any subsequent market strength, without a great deal of exposure to further market weakness should it emerge.
My guess, based on an extensive review of market internals here, is that even a modest further decline in the market will place the Market Climate in the most hostile of conditions we identify – rich valuations, unfavorable market action, and rising yields. If we can clear this overbought condition without further internal deterioration, it would be somewhat surprising, but such a surprise would also be an indication of a continuing preference of investors to assume risk. It's exactly that surprise that would be evidence in favor of a moderate speculative exposure to market fluctuations, again primarily using call options.
In any event, our range of potential exposure to market fluctuations here is rather limited, due to the continuing rich valuation of the market. Suffice it to say that we remain fully hedged here, but are willing to accept a moderate – by no means aggressive – exposure to market fluctuations given sufficient evidence in the weeks ahead.
As of last week, the Market Climate for stocks was characterized by unfavorable valuations, tenuously favorable market action on the basis of market internals and broad price trends, and a combination of overvalued, overbought, overbullish, yields-rising conditions that have historically been associated with stock market returns below Treasury yields until those conditions have cleared. The Strategic Growth Fund remains fully hedged, with a “staggered strike” position that provides greater defense against market weakness, at the cost of lower “implied interest” on our hedge. Though this position can generate minor day-to-day movements opposite to market fluctuations, it is important to remember that the total amount at risk (versus a “flat” hedge) is only about 1% of assets, which again, is financed by the implied interest on our hedge. Even when valuations and market action are unfavorable, the dollar value of our hedge is limited to the value of our long holdings (though losses might still occur if our stocks were to perform poorly or if we experience a net decay in option time-value).
In bonds, the Market Climate was characterized by relatively neutral valuations and unfavorable market action. My impression is that foreign holders of U.S. Treasuries were no small players in the abrupt spike in interest rates last week. The U.S. is essentially consuming at the table of China and other nations, happy to finance our consumption and government deficits by writing IOUs to foreigners and saying “See, they're willing to lend us the money! They're funding our deficits by the billions every day! And nothing bad is happening! This can go on forever!” Meanwhile, foreign holders have now accumulated half of the float in U.S. Treasury securities, and are increasingly eyeing our real assets – witness China's deal to purchase part of Blackstone Group so it can expand its purchase of what would otherwise remain our property if we were less profligate in our consumption and government spending.
Meanwhile, investors should not be so naïve as to believe that money “flows into” one investment and “flows out of” another. Every security issued exists until it is retired. Every Treasury security outstanding has to be held by someone. If one holder wishes to sell, another must purchase it, or prices will decline until a purchaser can be found. It is simply not true that if bonds are sold stocks must rise because “the money has to go somewhere.” The bonds that are sold are simply bought by other investors at a price that induces the trade. Period. There is no more "money on the sidelines" after the transaction than there was before. All security prices can decline at once if investors generally become less willing to accept risk. Every dollar taken “out” of the market by a seller is brought “into” the market by a buyer.
If foreign interest rates are increasing abroad, we do not require rampant selling volumes in the U.S. to prod interest rates higher here. All that is required is a reduced willingness of foreigners to buy our bonds (or an increased willingness to sell them) at prevailing prices. As soon as that happens, there are only two outcomes. We can either step up our own willingness to buy them in an amount that makes up for the lost demand (or absorbs the increased supply), or failing that, bond prices will decline to the point where foreign investors are once again willing to continue buying (or are no longer eager to sell). If we buy the bonds issued by the Treasury ourselves, we directly finance the federal deficit. If we buy foreign goods and services instead, we then require foreigners to buy the bonds that we did not. Everything adds up.
A final observation - given the extremely elevated and overbought condition of global stock markets, not just here in the U.S. but nearly everywhere, the combination of extended, uncorrected stock market advances and rising yield trends could invite a strikingly coordinated decline. Interest rates are already rising globally, and the U.S. trends are part of a broader picture. As I used to teach my international finance students, international diversification can be very useful over long periods of time – but it generally fails at precisely the point where it is most needed, because market declines tend to be globally coordinated. That's not a forecast, but it is useful to remember given the enthusiasm of investors for international investments at present. This could be an interesting few weeks.
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