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October 22, 2007

Forget the Lesson, Learn it Twice

John P. Hussman, Ph.D.
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Just a note - both the Strategic Growth Fund and the Strategic Total Return Fund achieved fresh highs on Friday. The intent of the Strategic Growth Fund is to outperform the S&P 500 over the complete market cycle, with smaller losses than a passive investment approach. We've certainly achieved that intended performance from the 2000 peak to the recent peak. My current focus, of course, is on the full cycle starting from the market low in 2002. I have no views about whether a bear market has started in stocks, because I don't really think in terms of bull and bear markets (which can only be identified in hindsight). Our strategy is to align our investment position with the Market Climate we identify, based on observable evidence, at any particular point in time. Still, regardless of whether or not a bear market has started, I believe the Fund remains on track to achieve its investment objective even when we measure the complete cycle from the 2002 bear trough to the next bear trough, whenever that occurs. Despite this summer's market decline, the S&P 500 still has not even experienced a 10% correction on a daily closing basis.

Our stock selection approach has evidenced stronger performance relative to the major indices in recent months. It appears that investors have become at least somewhat more realistic about credit risk and potential earnings volatility, which we're observing in a somewhat weaker preference for speculative stocks. We certainly don't require investors to abandon their speculative biases, but it is welcome to see renewed interest in stocks having favorable valuations, solvent balance sheets, and stable revenue growth.

Are Hindenburgs ominous?

I've had a few questions about the “Hindenburg Omen” in the past week. Though I don't follow this indicator closely, the topic is interesting here because we observed three consecutive signals on Tuesday, Wednesday and Thursday. Those signals are at least worth mentioning because they corroborate the concerns about the market we were already getting from other distinct indicators. I mentioned the Hindenburg indicator in April 2006 when couple of signals appeared, which in hindsight, were followed by a 7.7% drop in the S&P 500 shortly thereafter.

“I've noted often that a great deal of the information conveyed by markets is contained in “divergences” between securities. While investors shouldn't read too much into any indicator, there's an interesting signal that has enough validity as a measure of divergence that it's worth mentioning here. Think of it as slightly more than entertainment value but far less than a reliable guide to investment.

“The signal is based on new highs and new lows, and is cheerfully called a Hindenburg (the actual name given to it by Kennedy Gammage is the 'Hindenburg Omen' but that strikes me as far too, well, ominous, because it's certainly not a sufficient condition for a market decline). Even based on the looser criteria that many analysts use, it's a relatively unusual event that has often preceded fairly substantial market declines with a fairly short lead time (usually within 30-60 days, including declines in 1987, 1990, 1998, 2000 and 2001), but has sometimes proved to be meaningless or insignificant as well (such as a cluster of signals in September 2005, among others).

"The basic elements are 1) the market is in a rising trend, defined as the NYSE Composite being above its 10-week average, 2) both daily new highs and new lows exceed 2.2% of issues traded, and 3) the McClellan Oscillator is negative – meaning that market breadth as measured by advances and declines is relatively weak (there's some dispute, which I will not join, as to whether the Oscillator has to be negative that day or turn negative later). Peter Eliades added a couple of other conditions to eliminate signals occurring in clearly strong markets: 4) new highs can't exceed new lows by more than 2-to-1, and 5) 2 or more signals occur within about a month (he uses 36 days) of each other. Eliades' criteria reduce the number of 'confirmed instances' to a smaller set with fewer false signals."

Though I wouldn't take the 3 consecutive signals last week as a compelling warning in themselves, I do think they deserve mention because they are occurring so close to unusually overvalued, overbought, overbullish conditions that independently warranted concern last week. With regard to our own measures relating to new highs and new lows, we observed a “leadership reversal” last week – a sudden flip from new highs dominating to new lows dominating, with significant numbers of both, within a few days of a market peak. Those reversals are generally a signal that there is an underlying “turbulence” in market internals, which is a symptom of increasing skittishness by investors.

On the positive side, Treasury bond prices behaved very well last week, despite widening credit default spreads on riskier debt. Though the underlying reason for that Treasury price strength was concern about economic weakness and credit defaults, falling bond yields do allow us to take a more constructive stance once market internals show evidence of improvement. Though we don't see that evidence yet, and continued economic and valuation risks are likely to keep us hedged with put option coverage in any event, it's possible that we could cover a portion of our short call option hedges if we do see some firming of internals.

The important thing to keep in mind here is that despite what I view as significant concerns about potential market weakness, we do have the flexibility to take somewhat more constructive investment exposures (though moderate, and without removing our put option defense) if market internals improve. In the meantime, our primary risk, as well as our primary source of expected return, is the potential for our stocks to perform differently than the indices we use to hedge. In short, I would characterize our investment stance as defensive, but flexible – in moderation – to any improvement in market internals that we might observe.

Forget the lesson, learn it twice

In addition to my overall concern about risks here, both to stocks and to the economy more generally, I think it's fascinating to watch how investors seem to partition certain stocks as if they are entirely “above the law” and impervious to any risk of overvaluation, “free entry” of competition, earnings dilution, margin erosion, or other factors. Investors took this view with dot-com and tech stocks in the late 1990's, with disastrous results (even for legitimate growth stocks like Cisco, which dropped from a bull market high of 82 to a bear market low of 8 with no intervening splits).

One way to identify these speculative darlings is to examine the extent to which investors focus on a growth story and blissfully ignore how a company treats them as shareholders. Speculative investors think of stocks as gambling stubs at the race track - they don't stop to think about the stream of cash flows that they can expect to actually receive as shareholders over the long-term.

Consider a possibly hypothetical company with $21 billion in tangible assets; two-thirds of which are IPO proceeds and about one-third of which are earnings that have been retained to-date. Now, if a company takes its IPO proceeds and invests them in cash and marketable securities, then as long as it doesn't generate net losses or other liabilities, the company must be worth at least the value of those assets, regardless of how much money was raised by issuing stock. Beyond that, however, any additional market value has to be backed up by an expectation that the company will actually deliver a stream of cash flows to shareholders over time.

What does “deliver” mean? Isn't it enough to report good earnings? Well, suppose that the 10-Q of this possibly hypothetical company notes that there are outstanding option grants to employees of 3.4 million shares at an average exercise price of $152, and another 11.5 million shares of outstanding option grants at an average exercise price of $244. If the current stock price is say, $645, you could whip out a calculator and confirm that the company has committed stock to employees worth $6.3 billion (the value in excess of the option strike prices), which is not much less than the total amount of earnings that have been retained to-date. That would be a lot like someone saying, “Hey man, I made a pizza for you,” eating it right before your eyes, and then saying “Hey man, I made two pizzas for you,” and eating those as well.

[Geeks Note: The disposal of retained earnings through option grants is not adequately captured in earnings deductions for “stock-based compensation.” The FASB did investors no favor when they allowed one-time costing options on estimated time-value at the grant date, without accruing costs period-by-period to reflect actual dilution by the date of exercise, which is what matters. See How and Why Options Should be Expensed From Corporate Earnings]

Often, companies use their retained earnings to “repurchase” stock, which is then handed over to employees as they exercise their stock options. What happens if the company doesn't repurchase stock? It simply dilutes the ownership claim of existing shareholders directly. The impact – a diversion of value from existing shareholders – is the same. For instance, suppose that the stock has a P/E of 50, and the company reports in its 8-K that “We currently anticipate that dilution related to all equity grants to employees will be at or below 2% this year.” A thinking investor might look at that and say, “Let's see. A P/E of 50 means that earnings represent 2% of the stock price, and the company is explicitly telling me that this is about the amount that will be given away in grants to employees.”

If you actually observed that sort of thing, you would probably conclude that investors had not learned much from the experience of stocks with similar characteristics during the 2000-2002 market plunge. That collapse demonstrated that there is often a spectacular difference between the market price of a speculative stock at the height of its popularity, and the actual value of the cash flows that an investor in that stock will realize by owning that stock over time. There's no denying that there were stunning gains in many of the dot-coms before they came back to earth, but the round-trip was ultimately distressing.

Aw, then again, forget I even mentioned it. That dot-com thing was a once-in-a-lifetime event. The “possibly hypothetical” example above couldn't really exist in the real world. Investors have surely learned their lesson. Everybody knows that.

Speaking of distressing round trips – as of Friday, the Dow and S&P 500 closed Friday within a fraction of a percent of where they were minutes prior to the Fed's September 18th interest rate announcement. And just for the record, the Fed has still added zero liquidity to the banking system. The total amount lent by the Fed to the banking system through the discount window fell again last week to just $240 million. Total bank reserves fell in September, from $44.9 billion to $42.5 billion. The monetary base – the only monetary aggregate that the Fed directly controls, fell in September from $853.482 billion to $851.279 billion. At least $19 billion of temporary repos will come due on Thursday, so the Fed won't be “injecting liquidity” into the banking system when it predictably rolls these over.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance. Last week's decline did clear some of the overbought conditions that have been a concern lately. Our measures of market action are still broadly unfavorable, and allowing even the mildest adjustment for profit margins and the position of earnings in the economic cycle, valuations remain rich. As noted above, we do have some flexibility to remove a portion of our short call options in the event that market action improves modestly. That would allow a more constructive investment exposure to any rebound, and maintain a significant defense against further losses, at the potential risk of time decay if the market was to move sideways. For now, we don't have enough evidence to depart from a fully hedged investment stance, but it's important to emphasize that we have no particular attachment to any view of stocks as being in a bear market or a bull market. Instead, we'll respond to observable, objective evidence as it evolves.

In bonds, Treasury securities performed very well, but are now significantly overbought. Barring immediate news of defaults and credit problems, my impression is that it may be difficult to keep yields at current lows without some correction, and that Treasuries remain vulnerable to sporadic inflation concerns. It's still probable that we'll see the year-over-year headline CPI inflation rate moving to about 4% by November (which is statistically “baked in the cake”). With the market apparently far more concerned with perception than reality when it comes to the Fed, any tendency toward higher inflation figures or substantial dollar weakness is likely to make investors fret that the Fed might not be able to “ease” as aggressively as it otherwise would. My view continues to be that all of this is psychological, but given how dependent overvalued markets can be on perpetually favorable psychology, the risk of any “disappointments” from the Fed could still be important.

The best approach, I think, is still to respond to changes in yields rather than trying to anticipate them. Accordingly, just as we increased our portfolio duration when interest rates spiked a few weeks ago, I reduced the duration of the Strategic Total Return Fund late Friday, to about 2.5 years. I would expect to increase that exposure again on any substantial, if temporary, increase in yields.

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