January 21, 2008
A Mixed Bag of Market Conditions
A market that is becoming less reckless is typically our friend. Last week, the stock market began to more seriously price in the risk of an oncoming recession, stocks representing reasonable value generally held up well, and some of the air came out of materials stocks and industrial cyclicals. International markets were hammered on Monday, with the U.S. market closed. The hardest hit sectors globally were financials, basic resources and cyclical stocks, so there may be more difficulty for similar U.S. stocks this week. A few of the perplexingly overvalued fertilizer stocks I mentioned last week have already plunged by about 30% in just four sessions, which isn't to say that investors won't drive them back up, but at least some of the speculative pillars are actually showing some faults. If there's any hope for the Fed to do a large “inter-meeting cut,” if only to put the brakes on investor panic, it will be Tuesday morning.
Investors often quote Keynes' remark that “Markets can remain irrational longer than you or I can remain solvent.” But provided that investors avoid positions that could threaten their solvency, irrational markets are at worst only a periodic nuisance. Moderately irrational markets are fine for us too, since we do respond to sentiment and speculative pressures to some extent. Still, there is usually a point where the risks dominate and we step aside. As a result, we won't track the market much in strongly speculative and overvalued markets, and we won't participate much when market leadership features low-quality stocks (poor earnings stability, debt laden balance sheets, cyclical profit margins, and low barriers to entry).
It's instructive that the total return of the S&P 500 over the past 4 years has now averaged just 5.7% annually, despite the fact that the recent decline is still well short of a minimal bear market. The return on the S&P is close enough to the return on risk-free Treasury bills that our hedging over this entire period has cost us close to nothing. Equally instructive is that the S&P 500 has now lagged Treasury bills since April 1998. Valuations do indeed drive long-term market returns.
The recent bull market began at the highest valuations of any prior bull market in history. It has predictably achieved below-average overall returns, and the cycle isn't even over yet. Though every market cycle is different, an “average” bull market represents a span of about 3.75 years, with total returns averaging about 27% annually, followed by a bear market of about 1.25 years, with total returns averaging about -27% annually. That means that, on average, a typical bear market loss of just over 30% has shaved a typical bull market gain of 145% down to a cumulative return of about 65% (for a full cycle of about 5 years and overall annual total returns of about 10.6%).
The failure to understand the dynamics of market cycles is a major reason why investors repeatedly overextend their risk near market peaks, hold onto their stocks over the full course of a bear market, and finally abandon stocks near market troughs. Though less than half of a typical bull market's gains typically remain by the end of a bear market, those bear markets rarely move in a straight line. Instead, they typically include several declines of 10-20%, punctuated by very hard rallies. As I've noted before, the 2000-2002 decline, which took the S&P 500 down by nearly half, included three separate advances of about 20% each (measured from intra-day low to intra-day high). These advances serve to keep investors “holding and hoping,” as Richard Russell would say.
It's important to recognize that “one-fell-swoop” market plunges typically feature rising interest rates, so even if the U.S. market follows through on the international weakness we saw on Monday, a bear market under current conditions would in all likelihood be punctuated by some powerful recoveries (though ultimately temporary - probably several weeks in duration) with additional failures later.
A mixed bag of market conditions
With regard to present market conditions, we currently observe a very mixed bag, depending on the horizon one chooses to emphasize. Over the very short term, the average stock is quite oversold, with a large proportion of stocks trading at the very lows of their trading ranges. International markets plunged on Monday, which is likely to spill over to further damage in the U.S. market. That said, it's not clear that there was not some “proxy selling” in the international markets by U.S. investors constrained by the Monday market closing. Given that, it's possible that the damage to U.S. markets may be more constrained than what we saw elsewhere.
In any event, the sort of “compression” we currently observe tends to be a setup for hard “clearing rallies,” though even a lag of a few days between the initial compression and the subsequent advance can inflict a good deal of interim damage. Suffice it to say that we should soon allow for the possibility of say, a sharp 5-10% market rebound over the course of a few days or weeks, even as we maintain a predominantly hedged and defensive investment stance.
Beyond that potential for some immediate weakness followed by a solid “clearing rally,” market conditions remain unfavorable overall. Valuations have come down, but remain well above historical norms (and significantly above levels that have typically marked the final trough of bear markets). The extent to which valuations look more reasonable depends on the measure one uses. On the basis of the highest level of S&P 500 earnings achieved to-date, the P/E ratio of the S&P 500 is now 15.6, which is not far from the level we observed at the 2002 low. The difficulty is that the current peak earnings figure is based on the highest profit margins in history, and implicitly embeds that assumption into the P/E multiple. Even if we assume that the multiple of 15.6 is reliable, it is no particular compliment to the market that the current multiple is similar to the one in 2002, since the overall returns we've observed since the 2002 low have been far smaller than past bull markets.
In contrast to accepting the recent level of profit margins as sustainable (as the price/peak multiple does to some extent), we can instead consider where the P/E of the S&P 500 would be if profit margins were fixed at their historical norms. In the graph below, that valuation is represented by the red line: the price/sales multiple. Note that values for the P/S multiple are on the right scale, but we can essentially read the “implied” P/E multiple off of the left scale. This is because the P/S multiple is essentially a scaled version of the P/E multiple that would exist if profit margins were fixed. At present, the P/E ratio of the S&P 500 would be about 21 if profit margins were at historical norms.
My impression is that the truth is somewhere between 15.6 and 21 (our preferred measure is at about 17.6, versus a historical norm since 1940 of about 14). In any event, valuations are still a significant distance above historical norms, and even further above levels that have represented compelling long-term buying opportunities.
Below is an updated chart of probable 10-year S&P 500 total returns based on a range of assumptions regarding terminal price/peak earnings multiples: 20 (the multiple at the 1929, 1972 and 1987 peaks), 14 (historical average), 11 (historical median) and 7 (the multiple at the 1974 and 1982 troughs). Currently, probable 10-year total returns range between extremes of -1% to +8%, with a most likely outcome between 3-5% annually.
The dark solid line tracks the actual 10-year total return of the S&P 500, which has historically been well contained within the range of projected returns except for a short-lived departure for 10-year periods that ended during the late 1990's bubble. Note that the total return for the past 10 years is at the higher band of the chart exactly because valuations are currently at the high end of historical experience. Even so, the total return of the S&P 500 for the past decade has been less than 5% annually. Suffice it to say that 10-year total returns of even 8% for the S&P 500 still represent an optimistic outlook.
Given my view that the U.S. economy has probably entered a recession, it appears fairly unlikely that the full decline in the S&P 500 will ultimately fall short of a minimal bear market decline of say, 20%. Taken from the market's recent high, that would set an initial expectation at about 1260 on the S&P 500. Of course, the average bear market has typically exceeded 30%, but I would be surprised if the market weakened below that level without producing a sustained clearing rally first.
That leaves us with a mixed bag of market conditions: major short-term compression that has a strong historical tendency to produce sharp clearing rallies, a likely recession underway that would set a 20% decline to about S&P 1260 as a likely first expectation, and gradually improving valuations that will ultimately translate into better prospects for long-term returns.
As usual, we don't need to make short-term forecasts or rely on “scenarios.” Our response to ongoing market conditions is to establish investment positions in proportion to the average return/risk profile that those conditions have historically generated. We currently observe the strong potential for a furious clearing rally, possibly several weeks in duration. At the same time, I don't believe that investors have fully priced in the expectation of a recession – the possibility of one, yes, but not the expectation. Overall, the weight of the evidence demands a continued strong defense, with a willingness to establish limited “constructive edges” on market weakness, using option combinations.
As I discussed last week, unlike the period between 2000-2003 when our stock selection approach substantially outperformed the indices we use to hedge (consistent with our experience since the 1980's), the market's focus on low-quality “garbage stocks” in recent years has not rewarded characteristics that have generally driven stock market returns over the long term – particularly reasonably valued, stable, deliverable cash flows .
Still, unless long-term stock returns are no longer tied to valuations or cash flows, I have no reason to believe this represents anything but a temporary phase, not unlike the market's exuberance for internet stocks in the late 1990's. When the investment approach is sound, patience is usually a virtue.
I should add parenthetically that our stock selection is driven by accounting-based valuation methods and fundamental analysis, with further measurement of market action and price/volume behavior (not by the sort of kitchen sink statistical estimations that seem to be increasingly the norm among quantitative hedge funds). Data has always been our largest non-payroll expense item, because we try not to leave stones unturned or methods untested – but we vastly prefer structural present-value methods to black boxes.
Finally, in interpreting the day-to-day fluctuations of the Strategic Growth Fund, it will be helpful to remember that the Fund is managed with the intent of outperforming the S&P 500 over the complete bull-bear market cycle with smaller periodic losses than a passive investment strategy, but it is neither a bear fund nor a market-neutral fund. The Fund can, has, and will reduce the extent of its hedging in market conditions that have historically been associated with a favorable return/risk profile.
Indeed, during the turbulent period from 2000 through mid-2003, there were nearly as many up months for the S&P 500 as there were down months, though the down months were more hostile. Even so, the average total return of the Fund during those up months for the S&P 500 was not far from the average return of the Fund during the down months (1.3% vs. 1.6%). In other words, the Fund's performance over periods of a few weeks or more was relatively independent of market direction, as intended. As always, Fund returns can be either positive or negative depending on how our stock holdings perform relative to the indices we use to hedge. The difference in performance between our stocks and those indices has been the main source of Fund returns since inception.
As of last week, the Market Climate for stocks was characterized by moderately unfavorable valuations (see the discussion above) and mixed market action (increasingly favorable short-term “compression” as the market declines, but otherwise unfavorable conditions). The Strategic Growth Fund remains predominantly hedged and defensively positioned against major market losses, but with modest positions (primarily using option combinations) that would “soften” our hedge in the event of a near-term advance. The next few weeks promise to be extremely volatile, so it is preferable not to seek excessive meaning in day-to-day returns, which will be heavily affected by exactly which sectors experience strength or weakness on any given day. We're defensively positioned and I view our stock holdings as being broadly undervalued relative to the indices we use to hedge, so I expect to weather continued market weakness if it emerges (though possibly with a few short-term losses as well, since again, the dollar value of our shorts never materially exceeds our long holdings). We do carry various underweights and overweights in various sectors, which may experience more or less day-to-day fluctuation than the major indices.
In bonds, the Market Climate was characterized by unfavorable yield levels but moderately favorable yield trends. Overall, the Strategic Total Return Fund currently carries a duration of about 2 years, mostly in TIPS. Meanwhile, gold stock prices dipped relative to the metal, driving the gold/XAU ratio over 5.0. Similar levels have historically been followed by very strong returns, particularly when U.S. interest rates are falling, inflation pressures persist, and U.S. economic growth is slowing. Downward pressure on real interest rates and by extension, the U.S. dollar, is generally followed by strong returns in precious metals shares. Accordingly, I used the recent price weakness in precious metals shares to bump the exposure of the Strategic Total Return Fund back toward 24% invested in that group.
In honor of Dr. Martin Luther King, Jr.
Loving Your Enemies
“I want to use as a subject from which to preach this morning a very familiar subject, and it is familiar to you because I have preached from this subject twice before to my knowing in this pulpit. I try to make it a, something of a custom or tradition to preach from this passage of Scripture at least once a year, adding new insights that I develop along the way out of new experiences as I give these messages. Although the content is, the basic content is the same, new insights and new experiences naturally make for new illustrations.
“So I want to turn your attention to this subject: "Loving Your Enemies." It's so basic to me because it is a part of my basic philosophical and theological orientation—the whole idea of love, the whole philosophy of love. In the fifth chapter of the gospel as recorded by Saint Matthew, we read these very arresting words flowing from the lips of our Lord and Master: "Ye have heard that it has been said, ‘Thou shall love thy neighbor, and hate thine enemy.' But I say unto you, Love your enemies, bless them that curse you, do good to them that hate you, and pray for them that despitefully use you; that ye may be the children of your Father which is in heaven."
“Over the centuries, many persons have argued that this is an extremely difficult command. Many would go so far as to say that it just isn't possible to move out into the actual practice of this glorious command. But far from being an impractical idealist, Jesus has become the practical realist. The words of this text glitter in our eyes with a new urgency. Far from being the pious injunction of a utopian dreamer, this command is an absolute necessity for the survival of our civilization. Yes, it is love that will save our world and our civilization, love even for enemies.
“Now let me hasten to say that Jesus was very serious when he gave this command; he wasn't playing. He realized that it's hard to love your enemies. He realized that it's difficult to love those persons who seek to defeat you, those persons who say evil things about you. He realized that it was painfully hard, pressingly hard. But he wasn't playing. We have the Christian and moral responsibility to seek to discover the meaning of these words, and to discover how we can live out this command, and why we should live by this command.
“Now first let us deal with this question, which is the practical question: How do you go about loving your enemies? I think the first thing is this: In order to love your enemies, you must begin by analyzing self. And I'm sure that seems strange to you, that I start out telling you this morning that you love your enemies by beginning with a look at self. It seems to me that that is the first and foremost way to come to an adequate discovery to the how of this situation.
“Now, I'm aware of the fact that some people will not like you, not because of something you have done to them, but they just won't like you. But after looking at these things and admitting these things, we must face the fact that an individual might dislike us because of something that we've done deep down in the past, some personality attribute that we possess, something that we've done deep down in the past and we've forgotten about it; but it was that something that aroused the hate response within the individual. That is why I say, begin with yourself. There might be something within you that arouses the tragic hate response in the other individual.
“This is true in our international struggle. Democracy is the greatest form of government to my mind that man has ever conceived, but the weakness is that we have never touched it. We must face the fact that the rhythmic beat of the deep rumblings of discontent from Asia and Africa is at bottom a revolt against the imperialism and colonialism perpetuated by Western civilization all these many years.
“And this is what Jesus means when he said: "How is it that you can see the mote in your brother's eye and not see the beam in your own eye?" And this is one of the tragedies of human nature. So we begin to love our enemies and love those persons that hate us whether in collective life or individual life by looking at ourselves.
“A second thing that an individual must do in seeking to love his enemy is to discover the element of good in his enemy, and every time you begin to hate that person and think of hating that person, realize that there is some good there and look at those good points which will over-balance the bad points.
“Somehow the "isness" of our present nature is out of harmony with the eternal "oughtness" that forever confronts us. And this simply means this: That within the best of us, there is some evil, and within the worst of us, there is some good. When we come to see this, we take a different attitude toward individuals. The person who hates you most has some good in him; even the nation that hates you most has some good in it; even the race that hates you most has some good in it. And when you come to the point that you look in the face of every man and see deep down within him what religion calls "the image of God," you begin to love him in spite of. No matter what he does, you see God's image there. There is an element of goodness that he can never slough off. Discover the element of good in your enemy. And as you seek to hate him, find the center of goodness and place your attention there and you will take a new attitude.
“Another way that you love your enemy is this: When the opportunity presents itself for you to defeat your enemy, that is the time which you must not do it. There will come a time, in many instances, when the person who hates you most, the person who has misused you most, the person who has gossiped about you most, the person who has spread false rumors about you most, there will come a time when you will have an opportunity to defeat that person. It might be in terms of a recommendation for a job; it might be in terms of helping that person to make some move in life. That's the time you must do it. That is the meaning of love. In the final analysis, love is not this sentimental something that we talk about. It's not merely an emotional something. Love is creative, understanding goodwill for all men. It is the refusal to defeat any individual. When you rise to the level of love, of its great beauty and power, you seek only to defeat evil systems. Individuals who happen to be caught up in that system, you love, but you seek to defeat the system.
“The Greek language, as I've said so often before, is very powerful at this point. It comes to our aid beautifully in giving us the real meaning and depth of the whole philosophy of love. And I think it is quite apropos at this point, for you see the Greek language has three words for love, interestingly enough. It talks about love as eros. That's one word for love. Eros is a sort of, aesthetic love. Plato talks about it a great deal in his dialogues, a sort of yearning of the soul for the realm of the gods. And it's come to us to be a sort of romantic love, though it's a beautiful love. Everybody has experienced eros in all of its beauty when you find some individual that is attractive to you and that you pour out all of your like and your love on that individual. That is eros, you see, and it's a powerful, beautiful love that is given to us through all of the beauty of literature; we read about it.
“Then the Greek language talks about philia, and that's another type of love that's also beautiful. It is a sort of intimate affection between personal friends. And this is the type of love that you have for those persons that you're friendly with, your intimate friends, or people that you call on the telephone and you go by to have dinner with, and your roommate in college and that type of thing. It's a sort of reciprocal love. On this level, you like a person because that person likes you. You love on this level, because you are loved. You love on this level, because there's something about the person you love that is likeable to you. This too is a beautiful love. You can communicate with a person; you have certain things in common; you like to do things together. This is philia.
“The Greek language comes out with another word for love. It is the word agape. And agape is more than eros; agape is more than philia; agape is something of the understanding, creative, redemptive goodwill for all men. It is a love that seeks nothing in return. It is an overflowing love; it's what theologians would call the love of God working in the lives of men. And when you rise to love on this level, you begin to love men, not because they are likeable, but because God loves them. You look at every man, and you love him because you know God loves him. And he might be the worst person you've ever seen.
“And this is what Jesus means, I think, in this very passage when he says, "Love your enemy." And it's significant that he does not say, "Like your enemy." Like is a sentimental something, an affectionate something. There are a lot of people that I find it difficult to like. I don't like what they do to me. I don't like what they say about me and other people. I don't like their attitudes. I don't like some of the things they're doing. I don't like them. But Jesus says love them. And love is greater than like. Love is understanding, redemptive goodwill for all men, so that you love everybody, because God loves them. You refuse to do anything that will defeat an individual, because you have agape in your soul. And here you come to the point that you love the individual who does the evil deed, while hating the deed that the person does. This is what Jesus means when he says, "Love your enemy." This is the way to do it. When the opportunity presents itself when you can defeat your enemy, you must not do it.
“Now for the few moments left, let us move from the practical how to the theoretical why. It's not only necessary to know how to go about loving your enemies, but also to go down into the question of why we should love our enemies. I think the first reason that we should love our enemies, and I think this was at the very center of Jesus' thinking, is this: that hate for hate only intensifies the existence of hate and evil in the universe. If I hit you and you hit me and I hit you back and you hit me back and go on, you see, that goes on ad infinitum. It just never ends. Somewhere somebody must have a little sense, and that's the strong person. The strong person is the person who can cut off the chain of hate, the chain of evil. And that is the tragedy of hate – that it doesn't cut it off. It only intensifies the existence of hate and evil in the universe. Somebody must have religion enough and morality enough to cut it off and inject within the very structure of the universe that strong and powerful element of love.
“I think I mentioned before that sometime ago my brother and I were driving one evening to Chattanooga, Tennessee, from Atlanta. He was driving the car. And for some reason the drivers were very discourteous that night. They didn't dim their lights; hardly any driver that passed by dimmed his lights. And I remember very vividly, my brother A. D. looked over and in a tone of anger said: "I know what I'm going to do. The next car that comes along here and refuses to dim the lights, I'm going to fail to dim mine and pour them on in all of their power." And I looked at him right quick and said: "Oh no, don't do that. There'd be too much light on this highway, and it will end up in mutual destruction for all. Somebody got to have some sense on this highway."
“Somebody must have sense enough to dim the lights, and that is the trouble, isn't it? That as all of the civilizations of the world move up the highway of history, so many civilizations, having looked at other civilizations that refused to dim the lights, and they decided to refuse to dim theirs. And Toynbee tells that out of the twenty-two civilizations that have risen up, all but about seven have found themselves in the junk heap of destruction. It is because civilizations fail to have sense enough to dim the lights. And if somebody doesn't have sense enough to turn on the dim and beautiful and powerful lights of love in this world, the whole of our civilization will be plunged into the abyss of destruction. And we will all end up destroyed because nobody had any sense on the highway of history.
"Somewhere somebody must have some sense. Men must see that force begets force, hate begets hate, toughness begets toughness. And it is all a descending spiral, ultimately ending in destruction for all and everybody. Somebody must have sense enough and morality enough to cut off the chain of hate and the chain of evil in the universe. And you do that by love.
“There's another reason why you should love your enemies, and that is because hate distorts the personality of the hater. We usually think of what hate does for the individual hated or the individuals hated or the groups hated. But it is even more tragic, it is even more ruinous and injurious to the individual who hates. You just begin hating somebody, and you will begin to do irrational things. You can't see straight when you hate. You can't walk straight when you hate. You can't stand upright. Your vision is distorted. There is nothing more tragic than to see an individual whose heart is filled with hate. He comes to the point that he becomes a pathological case. For the person who hates, you can stand up and see a person and that person can be beautiful, and you will call them ugly. For the person who hates, the beautiful becomes ugly and the ugly becomes beautiful. For the person who hates, the good becomes bad and the bad becomes good. For the person who hates, the true becomes false and the false becomes true. That's what hate does. You can't see right. The symbol of objectivity is lost. Hate destroys the very structure of the personality of the hater.
“The way to be integrated with yourself is be sure that you meet every situation of life with an abounding love. Never hate, because it ends up in tragic, neurotic responses. Psychologists and psychiatrists are telling us today that the more we hate, the more we develop guilt feelings and we begin to subconsciously repress or consciously suppress certain emotions, and they all stack up in our subconscious selves and make for tragic, neurotic responses. And may this not be the neuroses of many individuals as they confront life that that is an element of hate there. And modern psychology is calling on us now to love. But long before modern psychology came into being, the world's greatest psychologist who walked around the hills of Galilee told us to love. He looked at men and said: "Love your enemies; don't hate anybody." It's not enough for us to hate your friends because—to to love your friends—because when you start hating anybody, it destroys the very center of your creative response to life and the universe; so love everybody. Hate at any point is a cancer that gnaws away at the very vital center of your life and your existence. It is like eroding acid that eats away the best and the objective center of your life. So Jesus says love, because hate destroys the hater as well as the hated.
“Now there is a final reason I think that Jesus says, "Love your enemies." It is this: that love has within it a redemptive power. And there is a power there that eventually transforms individuals. That's why Jesus says, "Love your enemies." Because if you hate your enemies, you have no way to redeem and to transform your enemies. But if you love your enemies, you will discover that at the very root of love is the power of redemption. You just keep loving people and keep loving them, even though they're mistreating you. Here's the person who is a neighbor, and this person is doing something wrong to you and all of that. Just keep being friendly to that person. Keep loving them. Don't do anything to embarrass them. Just keep loving them, and they can't stand it too long. Oh, they react in many ways in the beginning. They react with bitterness because they're mad because you love them like that. They react with guilt feelings, and sometimes they'll hate you a little more at that transition period, but just keep loving them. And by the power of your love they will break down under the load. That's love, you see. It is redemptive, and this is why Jesus says love. There's something about love that builds up and is creative. There is something about hate that tears down and is destructive. So love your enemies.
“There is a power in love that our world has not discovered yet. Jesus discovered it centuries ago. Mahatma Gandhi of India discovered it a few years ago, but most men and most women never discover it. For they believe in hitting for hitting; they believe in an eye for an eye and a tooth for a tooth; they believe in hating for hating; but Jesus comes to us and says, "This isn't the way."
“As we look out across the years and across the generations, let us develop and move right here. We must discover the power of love, the power, the redemptive power of love. And when we discover that we will be able to make of this old world a new world. We will be able to make men better. Love is the only way. Jesus discovered that.
“And our civilization must discover that. Individuals must discover that as they deal with other individuals. There is a little tree planted on a little hill and on that tree hangs the most influential character that ever came in this world. But never feel that that tree is a meaningless drama that took place on the stages of history. Oh no, it is a telescope through which we look out into the long vista of eternity, and see the love of God breaking forth into time. It is an eternal reminder to a power-drunk generation that love is the only way. It is an eternal reminder to a generation depending on nuclear and atomic energy, a generation depending on physical violence, that love is the only creative, redemptive, transforming power in the universe.
“So this morning, as I look into your eyes, and into the eyes of all of my brothers in Alabama and all over America and over the world, I say to you, "I love you. I would rather die than hate you." And I'm foolish enough to believe that through the power of this love somewhere, men of the most recalcitrant bent will be transformed. And then we will be in God's kingdom.”
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