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June 18, 2007

New Economy, or Unfinished Cycle?

John P. Hussman, Ph.D.
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The major stock indices recovered toward their prior highs last week, after a shallow correction that was not nearly sufficient to clear the prevailing overbought, overbullish conditions in the market. When the market is fluctuating near its highs, it can be easy to forget that markets move in cycles rather than lines over time. It's similarly easy to forget how effective corrections and bear markets are in eliminating most or all of late-stage bull market gains.

I've noted before that the average bear market eliminates more than half of the gain achieved during the prior bull market. Substantial corrections do serious damage as well. Currently, even a 15%, one-year decline in the market – not even qualifying as a bear market – would put the 4-year return on the S&P 500 within 1% annually of Treasury bill returns. From the standpoint of returns since the 2002 low, such a correction (well short of a bear market) would leave the market's gain prior to about March 2004 unscathed, but the market's edge over-and-above Treasury bills since then would be erased.

Measured off of virtually any point except the depths of the 2002 market trough, a 15% market decline would put annualized S&P 500 returns into the low or mid-single digit range for nearly every period since 1997, including recent years.

It's also important to emphasize that standard bear market declines have historically produced losses averaging about 30% - generally not just 20% (15% declines don't even qualify). I don't expect the next one to be a significant exception. Yet even if an eventual bear market that someday follows this advance is restricted to a decline of just 20%, investors buying here will still lag Treasury bills from today until the next bear market trough, unless stocks rise another 30% over the next year, 36% over 2 years, 42% over 3 years, or 49% over 4 years, depending on how long it takes for that bear market to emerge.

[Geeks Note: The general calculation here is 1.045^N / .80 – 1 for N years. For example, Treasury bills will earn about 4.5% this year, but if the market gains 30% to a peak and then subsequently declines 20% to a low one-year from today, the overall return would be just 4% (1.3 x 0.8 -1). If a 20% decline hits its trough two years from now, T-bills will earn about 9.2% compounded in the interim, while the 20% decline would still shave a 36% gain to just 8.8%.]

Suffice it to say that the only reason to buy stocks here is a) the belief that one can sell them to a greater fool at higher prices despite already overvalued, overbought, overbullish and rising yield conditions, or b) the belief that the stock market will soar 30-50% from these levels, without experiencing even a minimal bear market in the next 4-5 years.

Sometimes, it is sensible to speculate to some extent, even in overvalued conditions, if market action indicates an appetite of investors for risk and the market is not overbought or excessively bullish. Sometimes, strong multi-year gains without an intervening bear market are reasonable to expect, but those periods generally begin at much more favorable valuations. I realize that there is a visceral urge to participate here, as well as a fear of missing out when the market is hitting new highs, but over the full market cycle, investing to achieve short-term comfort costs a fortune.

Presently, the market's valuation on the basis of price/revenue, price/book, and price/dividend is higher than at any prior historical market peak on record except the 2000 peak. On the basis of normalized profit margins, the current P/E for the S&P 500 would be about 25 times record earnings rather than the (still elevated) multiple of 18.4. Even if we give only 25% weight to that normalized value, and give 75% weight to the prevailing multiple, the resulting P/E for the S&P 500 is still over 20, and is about the same as what prevailed prior to the 1929, 1973-74, and 1987 market plunges. This market is only “cheap” if one couples non-GAAP “forward operating earnings” with the Fed Model. As I've detailed in recent weeks, that approach has ridiculous implications even in the data sample (1980-2000) that was used to construct it, and is quickly and easily verified as pure garbage in pre-1980 data, using any proxy remotely close to estimated “forward earnings.”

Still, it bears repeating that if one adheres to the Fed Model, stocks are currently far cheaper than they were at the historic 1982 lows, but as expensive as they were at the 1929 peak. If that seems sensible, then nothing I say can help.

New economy, or unfinished cycle?

Shouldn't we change our investment approach to get “in synch” with the recently rising trend of the market? Though it would be preferable for us to have captured a greater portion of market gains lately, particularly during the past 10 months, the fact is that giving greater weight – in hindsight – to those variables that could have kept us more aggressive in this specific instance would also have produced lower returns and deeper losses on a longer historical basis.

The acceptable changes to an investment model or strategy are not simply those that would have performed better in the most recent instance. They also must have performed well in split samples over a wide range of history, and preferably also in a testing sample that was not used to create the strategy in the first place. One cannot simply say after the fact, “well, this indicator is better because it would have kept you in lately” if the indicator in fact underperforms your existing strategy when tested over time. That's my difficulty not only with the Fed Model, but with many alternative investment approaches.

Meanwhile, the fact is that stocks have underperformed Treasury bills for more than 8 years. It's difficult to make a statistical argument for abandoning our valuation methods when they have performed well not only historically, but in fact over the past 8 years. The argument for abandoning these historically reliable valuation methods is based on a much shorter period during which stocks have appeared overvalued but have still gone up, with the main disparity occurring over the past 10 months. This isn't evidence that normalized valuations don't work anymore, but is simply evidence that investors have had a tenacious appetite for speculative risk. We might be inclined to take a modest amount of speculative risk on that basis were it not for the prevailing combination of overvaluation, overbought conditions, overbullish sentiment and rising bond yields.

History repeats – the argument for abandoning prevailing valuation methods regularly emerges late in a bull market, and typically survives until about the second down-leg (or sufficiently hard first leg) of a bear. Such arguments have included the “investment company” and “stock scarcity” arguments in the late 20's, the “technology” and “conglomerate” arguments in the late 60's, the nifty-fifty “good stocks always go up” argument in the early 70's, the “globalization” and “leveraged buyout” arguments in 1987 (and curiously, again today), and the “tech revolution” and “knowledge-based economy” arguments in the late 1990's.

Speculative investors regularly create “new era” arguments and valuation metrics to justify their speculation. But you don't change your investment strategy based on half of a market cycle (or less). You can certainly refine it gradually based on new evidence. Still, if your strategy has performed well historically, and also over the most recent full cycle to-date, it is not at all clear that it should be modified. Certainly not at bull market highs, and certainly not for “new era” arguments saying that all of history has magically become irrelevant.

Market Climate

As of last week, the Market Climate for stocks was characterized by unusually unfavorable valuations, tenuously favorable market action on the basis of price trends, and a combination of overvalued, overbought, overbullish, rising yield conditions that has generally produced a negative return/risk profile for stocks, on average.

Our current investment position in the Strategic Growth Fund will tend to produce relatively flat returns on a sustained advance, positive returns on market losses that move the S&P 500 below the strike prices on our put option hedges, and brief negative returns on market rallies recoveries that take our hedges back “out of the money” before we have a good opportunity to lower those strikes. While we will tend to exhibit positive returns on “breakdown” days where the market moves from being above our strikes (as it is now) to a position below those strikes, and brief negative returns on “recovery days” where the market moves from being below our strikes to being above them, it is essential to remember that the overall capital we have at risk (versus a “flat” hedge) is currently less than 1% of assets, essentially financed with implied interest that we earn on our overall hedge position.

In other words, we are not carrying a “bearish” position where an extended market advance would be expected to produce extended losses. Rather, we are intentionally trading flat returns in the event of an uncorrected (or shallowly corrected) extension of an already overextended advance, in return for the expectation of positive returns in the event of any material correction. Once we observe even a moderate correction of perhaps 4-5%, I would expect to move to a “flat” hedge where we would expect total returns equal to implied interest of about the T-bill rate, plus or minus the difference in performance between the stocks we hold and the indices we use to hedge. In the unlikely but possible event that the market clears its overbought condition without a serious deterioration in the quality of market action, I would expect to remove perhaps 20-30% of our hedges outright.

For now, the Fund remains fully hedged, with a “tilt” that trades the implied interest on our hedge for a stronger defense against market losses.

In bonds, the Market Climate was characterized last week by relatively neutral valuations and moderately unfavorable market action. It is far from clear that bonds “hit bottom” last week, particularly given evidence that much of the retreat in bond prices was indeed driven by a shift in foreign central bank purchases of U.S. Treasuries.

Though the “bullish spin” on this is that foreigners are investing in equities instead of bonds, the abrupt drop in Treasury bill yields in recent days, particularly Friday, has me concerned (particularly when contrasted with rising Treasury bond yields). It's not plausible that that decline reflects any material change in inflation expectations (the 0.1% number on Friday's core CPI rather than the expected 0.2% was due to minuscule rounding error – the precise figure was 0.14978…). Nor does it reflect a change in probabilities of Fed Funds shifts, since those futures contracts have remained quite stable. That suggests that we're observing an abrupt shift in preferences for a “safe haven” maturity rather than for longer maturities.

My guess – and it's just a guess – is that this sort of instability in foreign demand may be a precursor to some currency volatility, and could elevate risk to the exchange value of the U.S. dollar. We observe historically that an abrupt widening of the yield curve with long-rates rising and short-rates falling tends to be followed by appreciation in gold prices stemming from dollar weakness.

Frankly, the reason for the shift isn't clear to me yet, but as the world-class chess player Battsetseg Tsagaan once told me, “when your opponent moves something suspicious, there has to be something wrong.”

In any event, we shouldn't count on a quick end to the recent volatility in the markets.

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