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April 21, 2008

Intentionally Avoiding the "Risk Trade"

John P. Hussman, Ph.D.
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Last week largely represented an unwinding of the “defensive trade” as investors embraced the "risk trade" instead – Treasury bond prices dropped sharply, and consumer staples and a number of other defensive sectors were down or relatively unchanged, even as financials and materials gained strength.

The pullback in the Strategic Growth Fund last week (-1.87%) was primarily attributable to those divergent industry returns, away from defensive sectors (staples, non-cyclicals, healthcare, etc) and toward risk sectors (financials, materials, cyclicals, internet) not heavily represented in the Fund.

We are intentionally avoiding such risk sectors on the expectation of further financial sector weakness, and because materials and cyclical stocks currently rely on sustained commodity price strength and “decoupling” between the U.S. and foreign countries. I continue to view commodities as cyclical, and decoupling as implausible – indeed, my impression is that the commodity surge will likely be turned on its head within a few months, about the point where 10-year Treasury yields move above the year-over-year CPI inflation rate. Having spent the mid-1980's working at the Chicago Board of Trade, I was always impressed how much more “V-shaped” commodity price charts were than equities or bonds. Spike tops, spike bottoms, and steep reversals are common. Investors overly tied to the commodity boom and “global demand” as drivers of investment positions would do well to examine that behavior. It is often initially painful, but ultimately worthwhile to remember that it's best to panic before everyone else does.

The market is again overbought in a still-unfavorable Market Climate, so I don't expect perceptions about economic, financial and earnings risk to remain suppressed for long. Still, we are always open to new evidence, and do not rule out a more constructive position if convincing evidence arrives. Although we still require improved market internals to warrant a speculative exposure to market risk, I would expect to remove a portion of our short call hedges if we observe sufficient follow-through in market internals.

I have frequently noted that one of the uses of “market action” is to gauge the extent to which investors have a robust willingness to speculate. Given the affection of investors for risk last week, it is natural to ask why we don't take that at face value and immediately accept a speculative exposure to market risk. The reason is that the recent shift toward greater speculation continues to appear very fragile. Trading volume has become dull when it should be expanding, the spread between commercial paper and Treasury bills has widened to the highest spread year-to-date (despite modest improvement in CDS spreads), and unlike robust speculative markets, we continue to observe divergent industry group behavior and selective leadership (still primarily materials and cyclicals).

Indeed, to the extent that we can take any information signal from developing market action, it is that we should revise our expectations to allow for a much more significant slowdown in consumer spending than we have anticipated thus far. If anything, the evidence suggests revising our expectations about consumer spending and economic prospects downward. Bill Hester's latest research piece (Consumer Spending Break-Down - additional link below) details some of these concerns.

Divergent internals have historically been unfavorable for the overall market - sustained advances typically feature broad uniformity across industry groups and security types and price/volume behavior indicative of strong demand and conviction – not simply a “backing off” of sellers in the face of short-covering.

As I've often noted, about the only point where I have an opinion about near-term market action is when the market is either overbought in an unfavorable Market Climate, or oversold in a favorable Climate. Given that the market is once again overbought in an unfavorable Market Climate, my impression is that the risk of a free-fall is significant. Aside from short-term speculative pressures (largely driven by relief about Bear Stearns), nothing in recent data suggests a material abatement of recession risk, mortgage risk, profit margin risk, or dollar risk.

Buzzword Bingo

See how quickly you can fill in a row, column or diagonal while watching the business channel, and you'll get an idea of the extent to which a brief relief rally has convinced analysts that all of the difficulties of the economy and the markets are behind us.

Market Climate

As of last week, the Market Climate in stocks remained characterized by unfavorable valuations and unfavorable market action. Several of the unfavorable features of market action are discussed above. With regard to near-term market action, we currently observe an overbought condition in an unfavorable Market Climate – a condition which is generally (but not always) followed by abrupt market losses. It is certainly possible that we could recruit enough strength in market internals to shift to a more favorable Market Climate (though with a continued drag from overvaluation).

Though valuation alone is not useful for projecting near-term returns, it provides a reliable gauge of prospective long-term returns. Our 10-year total returns projection for the S&P 500 (based on standard methods) remains in the 2-4% range, with -1.5% at the lower extreme and 7.5% at the upper extreme.

One might argue that the mid-range projection for stock returns is, in fact, competitive with bond yields, since 10-year Treasury yields are also about 3.8%. The difficulty with that sort of perspective should be obvious.

Periods of rich valuations are frustrating because they prevent us from taking unhedged or leveraged investment positions. This is normally very comfortable to do for a significant portion of market cycle. Because the 2003 lows occurred at the highest valuations of any prior bear market trough in history, we were only able to remove 70% of our hedges. If the market trough a few weeks ago represented a final bear market low, it would be yet again at the highest level of valuation in history for a bear market trough, and the lack of compelling improvement in market action from the recent low will also have delayed a favorable shift in the Market Climate beyond what we normally observe at the start of a new bull market cycle.

Frankly, it's difficult to believe that we've observed the market's final low. Bear markets associated with recessions tend to be deeper and longer in duration than average, particularly in periods of “secular” revaluation (which I believe we've been in since 2000). It bears repeating that the total return of the S&P 500 has lagged Treasury bill returns since July 1998 – both about 3.3% annually, though with T-bills doing slightly better. The S&P 500 has also lagged Treasury bills over the past 18 months even with the recent advance. My impression is that by the time the present market cycle is complete, 2003 will be the only bull market year for which the returns of the S&P 500 in excess of Treasury bills will be preserved.

In bonds, the Market Climate last week was characterized by moderately unfavorable yield levels and unfavorable market action. The compression we observed in Treasury yields in recent months was suddenly relieved last week, as yields surged and prices dropped sharply. Though I still do not view current bond yields as offering much investment merit, they are more consistent with the combination of economic weakness and still persistent inflation that we observe. Most likely, we'll see further abrupt demand for Treasuries as “safe-havens” in the months ahead, but taking an investment position on that basis remains purely speculative. The Strategic Total Return Fund continues to have an unusually short duration, primarily in Treasury bills.

Meanwhile, we are gradually clipping our exposure to precious metals shares (currently just over 15% of assets in Strategic Total Return) on periodic strength. I don't expect commodities prices to weaken immediately, but once we observe a shift toward positive real interest rates (particularly if inflation rates abate somewhat while Treasury yields remain in the current range), even a favorable valuation in terms of say, the gold/XAU ratio, won't forestall weakness in precious metals shares. Suffice it to say that we remain constructive for now, but are using any unusual strength to lighten our remaining exposure.

New From Bill Hester: Consumer Spending Break-Down

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