June 25, 2007
Does ripe fruit never fall? Or do the boughs
- Wallace Stevens, "Sunday Morning"
In the microscopic focus on day-to-day fluctuations in the market, it is easy to overlook how unusual – specifically, unusually unfavorable – current market conditions are from a long-term historical perspective. The S&P 500 is currently at 18 times record net earnings (never mind that these earnings are also on record profit margins, so that the market is also implicitly pricing in permanently high expectations for these margins – on normalized margins the P/E would be above 25). Bond yields are rising. Price trends remain strenuously overbought. The Investor's Intelligence figures put advisory bulls at 53.3%, with bears at an unusually low 18.9%.
If we look historically at points where similar conditions held true, we find April 1965 (swiftly followed by a market plunge), December 1972 (the beginning of the '73-74 decline which took stock prices down by half), August 1987 (no comment), July 1999, December 1999, March 2000 (all three of the latter followed by separate drops of 9-16%), and a few instances closely surrounding those dates.
It's notable that while we have not observed even a 10% correction since 2003, the corrections that we have observed also had their origins in (somewhat milder) combinations of overbought conditions, high bullishness, and rising yields (either Treasury bond yields or Treasury bill yields).
Recent conditions fall into a more restricted group of instances that have invariably been cleared by abrupt and generally deep losses. The market appears decidedly vulnerable. Also, it's worth observing that while the major indices have not experienced severe losses, our measures of internal market action are rapidly weakening, to the point where we can no longer identify even price/volume behavior as favorable. Virtually any weakness at all in the coming sessions will suggest a measurable shift in the willingness of investors to speculate, at which point conditions would fall into the most hostile Market Climate we identify.
As usual, we need not make forecasts, nor do we rely on them. We are always fully invested in a diversified portfolio of individual stocks (on the expectation that they will perform better over time than the indices we use to hedge), and take an unhedged position when the evidence suggests some combination of investment merit (based on valuations) or speculative merit (based on market action and a variety of technical factors). Market valuations have been unfavorable for some time. More recently, with the exception of a brief period following the February-March decline, overbought, overbullish conditions have outweighed the speculative merit of favorable market internals. Now, not even market internals support a speculative exposure to stocks. We have no basis for anything other than a hedged position.
As for the argument that stocks have support because the forward earnings yield is still above the 10-year bond yield, I can only repeat that this theory is based on a statistical artifact that can be easily refuted by a simple examination of historical data prior to 1980. I continue to believe that the first investors who abandon the Fed Model will be substantially better off than the last ones to abandon it. Some links to those prior comments on this topic:
June 4, 2007 - Speculating on Speculation
It's also important to recognize how strenuously overextended international markets are at present. This can only exaggerate the impact of any shift in the preference of investors away from risk. With valuations rich, stock markets almost universally overbought, bullishness extremely high, and mutual cash levels the lowest on record, it seems very much like everybody is in because they expect everybody to get in, not knowing that everybody is already in.
The question is not whether there is more “money on the sidelines” – as I've argued before, there is no such thing (e.g. The "Money Flow" Myth and the "Liquidity" Trap ). The question is whether the speculators holding stocks here (unhedged) will encounter others willing to lift those stocks from their hands at higher prices, and what happens if they don't.
As of last week, the Market Climate for stocks was characterized by unfavorable valuations, rapidly deteriorating market action (“internals”), and a combination of overvalued, overbought, overbullish conditions that has historically been associated with market returns below Treasury bill yields, on average, even when market internals and other measures of price action have been favorable.
In the Strategic Growth Fund, we have “staggered” the strike prices of our option combinations in a way that provides somewhat better downside protection (at the cost of less “implied interest” earned on our hedges), but we are not “betting on” a market decline. The difference between our current position and a “flat hedge” continues to be only about 1% of assets. The Strategic Growth Fund remains within 2% of its all-time high, and we are not positioned in a way that would be expected to generate sustained losses in the event of a continued market advance.
In order to interpret day-to-day fluctuations, it bears repeating that 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 recoveries that take our hedges back “out of the money” before we have a good opportunity to lower those strikes. We will tend to exhibit positive returns on “breakdown” days where the market moves from being above our strikes 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.
In bonds, the Market Climate last week was characterized by relatively neutral valuations and unfavorable market action, holding the Strategic Total Return Fund to a short 2-year duration, mostly in TIPS, with about 20% of assets in precious metals shares, where the Market Climate remains favorable on our measures.
I continue to be concerned about the behavior of various yield spreads. As I noted last week, the combination of falling short yields and rising long yields is frequently associated with U.S. dollar depreciation risk. Meanwhile, commercial paper and other credit-sensitive yields have been stable or rising even at short-term maturities, which we observe as a sharp widening in credit spreads particularly at the short end. Though it is clear that economists are expecting second quarter economic statistics to come in fairly strong, the wider spreads may portend some further weakness ahead, particularly given the sharply reduced rate of mortgage equity withdrawals, falling demand momentum, increasing housing delinquencies, emerging shortfalls in state tax revenues, and other factors.
Until we observe a clear widening in a variety of credit spreads across all maturities, we may not have enough evidence to warrant a longer duration exposure in the bond market. Still, my impression is that talk of a sustained economic rebound is somewhat overstated here.
Entertaining things to watch this week: in stocks, unbalanced breadth or heavy trading volume to the downside, and any breakout in the number of stocks establishing new lows; in bonds, credit spreads.
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