October 27, 2008
Risk Management and Hooke's Law
Though I continue to view stocks as reasonably undervalued, I'm a bit concerned that so many investors appear to be looking for a bottom. The S&P 500 currently reflects the best valuations since the 1990 bear market low. Even in the event of a continued bear market, stocks are increasingly likely to experience a powerful bear market advance, perhaps on the order of 20-25% toward the 1100 area on the S&P 500. However, we've observed little follow-through from the early price/volume improvements of a week ago, suggesting that even while traders are attempting to catch a potential rally, they are demonstrating little commitment to whatever purchases they are making in this area.
We aren't trying to catch a rally – we are gradually building an investment exposure based on valuations. Our investment response to undervaluation is straightforward: we establish investment exposure in proportion to the return/risk profile that we can expect from prevailing conditions, on average. At the 2002-2003 lows, stocks never got to the point of undervaluation, so we remained fully hedged until we observed a shift to favorable market action in the spring of 2003, at which point we quickly removed 70% of our hedges. In a market that has become undervalued, however, the strategy of waiting for a measurable improvement in market action historically has not performed nearly as well as a strategy of gradually increasing market exposure, on declines, as the market's valuation improves. Scaling in that way is certainly not comfortable, but the willingness to experience short-term discomfort is a scarce and ultimately well-compensated resource on Wall Street. The key is to scale gradually and in proportion to the expected return profile, rather than trying to “time” reversals that can't be predicted.
My sense is that many traders are willing to establish some exposure to market risk here, but they've also got a finger hovering over the sell button. So while they are holding onto long positions, their commitment is extremely tentative. If the market was to substantially break below, say, the 800 level on the S&P 500, I suspect that many traders would hit that button. That's not investing – that's trying to “play” the market.
So traders may try to “catch the lows” if the S&P 500 drops to the 830 area again, but I would expect that subsequent failure into the 700's could send those same traders, as well as skittish investors, rushing to sell at any price. The increasing chatter about “trading a rally” rather than “investing for value” makes me suspect that we shouldn't rule out a decline into the 700's, where I expect value-oriented investors to take a firmer stand. As noted below, we have to allow for both an immediate rebound, as well as a substantially larger decline. Within that range, we should observe reasonably strong support about 9% below current levels (an educated guess which we don't rely on and neither should you), which would bring the cumulative loss in the S&P 500 from last year's peak to about 48%.
Sorry for the splash of cold water, but my view is that the market is undervalued, that it is priced to deliver attractive long-term returns, and that there is an increasing likelihood of a major bear market advance – but I don't believe that any of this puts a “floor” below the market in the very short term, and I don't believe markets are apt to bottom while everyone is still looking for a bottom.
As an economist, it's clear that the parallels to 1929 are terribly overblown, not least because unlike the Great Depression, governments in this instance have opened a floodgate of liquidity, capital and base money – which they failed to do back then. Even if we were to completely zero out two solid years of earnings for the S&P 500, the fact is that more than 90% of the value of U.S. stocks would reside in the cash flows beyond that point. The main issue for good, established companies here is not the risk to the long-term stream of cash flows, but to what extent the uncertainty about the coming year or two of earnings will frighten investors to sell at depressed prices (thereby pricing stocks to deliver even higher long-term returns).
Profit margins did achieve higher levels in the past cycle than I would expect on a sustained long-term basis, but that observation is already factored into our analysis of valuation. We're always open to evidence that would change our analysis of very long-term growth prospects for the U.S. economy, but that evidence evolves slowly enough that we could easily see another complete bull-bear cycle in the interim. We don't follow a purely quantitative or mechanical investment approach, so context does matter, but we generally don't assume that the regularities (if not laws) of economics and finance have been entirely suspended. One of those laws is that a stock is a claim on a very long-term stream of future cash flows, and very little of the value is attributable to the first year or two. Market crashes are invariably about risk premiums, not long-term cash flows.
In the Strategic Growth Fund, we've got put option coverage below nearly all of our stock holdings, but we are not short the corresponding call options. As a result, we certainly expect some impact from local market fluctuations (both positive and negative), but expect to have a muted sensitivity to any major breakdown. Our put option defenses do not defend against movements of a few percent, but are in place to protect against unacceptably large downside risk in the event of severe additional market losses. At the same time, shareholders can expect that we will gradually reduce the extent of our put option coverage in the event that the market does decline significantly more.
Risk management and Hooke's Law
Successful long-term investors set investment positions that are consistent with their tolerance for risk, they expect periodic losses, and they tend to increase their investment exposure gradually as the market declines significantly. Last week, Warren Buffett didn't say “I'm all in because I think this is the bottom.” Rather, he said “If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.” That phrase implies that Buffett knows his own risk tolerance, and that he is scaling into stocks gradually as their prices decline and their expected long-term returns increase.
There's a general relationship in physics called Hooke's Law, which applies to springs: “as the extension, so the force.” My impression is that the stock market behaves much the same way. When investors are very skittish, the market may behave like a very loose rubber band, generating little tension even as it moves significantly away from fair value. But as risk aversion abates, the tension becomes much more like a stiff spring, and the potential to return forcefully toward normal valuations becomes enormous, particularly when the distance from fair value is large.
[Geek's Note: Adding up the cumulative tension described by Hooke's Law gives you a measure of the “potential energy” stored in the spring, which is proportional not to the distance the spring is pulled, but to the square of that distance. This observation has a nice analogy to finance, in terms of how investors should scale into a falling market. Taking the basic dividend discount model as an example, if the growth rate is 6% and the initial yield is 3%, it takes a 25% drop to increase long-term returns from 9% to 10%. From there it takes another 20% drop (40% cumulative) to increase long-term returns to 11%. From there, it takes a drop of 16.7% (50% cumulative) to increase long-term returns to 12%.]
Generally speaking, it takes smaller and smaller price declines to produce the same increment to expected returns, suggesting that investors should initially scale slowly, but accelerate their scaling as prices decline substantially.
The way investors do violence to their financial security is to establish an investment position outside of their actual tolerance for risk, believing they can manage that risk by panicking to sell if the market drops lower. As prices drop, poor investors set an ultimatum for the market by saying, “If this thing loses one more dime, I'm out.” Invariably, the thing will lose that dime and the the investor will get out near the bottom, having taken most of the losses, but abandoning any prospect for recovery and subsequent growth.
The time for fear is when stocks are strenuously overvalued. The time for panic is when they are overvalued and market internals begin to deteriorate. We are now beyond the time for fear, and beyond the time for panic. Still, we are not yet to the point for aggressive investment positions. Rather, we are at the point where investors should be gradually increasing their exposure, open to the possibility that stocks could decline still lower. If they do, long-term investors should cheer, because lower prices will mean better long-term return prospects, and will be an opportunity to increase investment positions further.
Keep in mind that the Strategic Growth Fund has been hedged in recent years because stocks have been priced to deliver disappointingly low long-term returns. That fact has now changed, and we are carefully and gradually changing our investment exposures accordingly. Still, it is important to contemplate the possibility of unexpected market outcomes, by avoiding investment positions that have a risk of intolerable losses if prices move against us.
An intolerable loss, in my view, is one that requires a heroic recovery simply to break even. A fully invested position in the S&P 500 has already experienced what I view as an intolerable loss, because the 43% loss from the high now requires a 75% gain just to break even. In contrast, a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally). As for the Strategic Growth Fund, we've experienced a 13.9% decline from the record high set a few weeks ago, which is uncomfortable, but can be reversed relatively easily. Long-term investors in the Fund should hope for a terrifying market plunge (I know I do), which would allow us to establish a more aggressive position in anticipation of very strong subsequent returns, though at the cost of some further short-term losses as we scale into that position. Short-term traders in the Fund should, as always, go somewhere else.
Trough Valuations in Bear Markets
The fact is that we can't rule out even extreme possibilities, such as a further drop in the S&P 500 by 30% to the 600 level. I absolutely do not expect the market to fall that much (particularly not in a single, uncorrected decline), but I can still tell you what we'll probably be doing if it does. At that point, I would expect to build up to a net investment exposure of at least 80%, without put option protection on that exposure, even if no aspects of market internals were favorable. I would view that allocation as conservative in view of those conditions. You can't manage risk effectively without contemplating extreme outcomes.
Still, even if this bear market is ultimately headed for a P/E of 7, a single one-way decline, uncorrected by a major rally, is extremely unlikely. Currently, the S&P 500 has declined by about 43% on a closing basis. In 1973-74, the market halted its overall decline at about 48%. Likewise in 1929, the market halted its initial decline at 48%, at which point stocks embarked on an advance of nearly 50% over the next 6 months before weakening again. Fear-mongerers like to point to the Great Depression, saying that an investor selling at the low in 1929 would have continued to lose until 1932, but they generally ignore the huge intermittent advances, and the fact that information accumulates slowly. Even in the worst of times, steep market declines tend to produce enormous (if ultimately impermanent) recoveries, as we saw even in the Depression.
To offer some additional context, Bill Hester put together the following charts. The first shows the extent and duration of every post-war bear market. The black line is the current decline, updated through Friday. Note that the worst of these were the 1973-74 bear and the 2000-2003 bear, both which terminated with losses of about 48%. Again, this is about the same loss as stocks experienced into their 1929 low, after which the market advanced by about 50% in the next 6 months.
The second chart is equally important. It shows the overall compression of the S&P 500 price-to-peak-earnings multiple in each of those post-war bear markets. Bill's main point here is that with the exception of the 1973-1974 bear market, the downturns that ended at single-digit price-to-peak earnings multiples also started at below-average multiples. Moreover, the 1973-74 case is something of an anomaly because S&P 500 earnings actually grew by over 50% during that bear market. On the basis of the highest level of earnings at the 1972 market peak, the 1974 bear market trough occurred at a P/E multiple of about 10. Currently, the S&P 500 trades at about 10.3 times the level of earnings observed last year. None of this provides any assurance that the market could not fall substantially further in this instance, but it should provide some context in which to interpret the size of the decline that has already occurred.
So just as we should allow for downside potential, we should also contemplate the potential for upside recovery. Even if the S&P 500 was to breach, say, the 600 level, investors should recognize that they would then have a long-term investment opportunity similar to the 1949, 1953, 1974 and 1982 lows. The only reason the S&P 500 hitting 600 would be harmful to a long-term investor is if that investor was to abandon stocks there. Investors sell at the lows because they forget the tendency of deeply oversold markets to recover, but the evidence is clear, time after time, that selling after extreme one-way declines is a poor decision.
As usual, we are adhering to our investment discipline, conscious of both potential risk as well as the increasing prospects for strong returns. It is important that shareholders recognize that the Strategic Growth Fund is a risk-managed, equity growth fund, not a market neutral fund and not a bear fund. Our intent remains to outperform the S&P 500 over the complete market cycle, with smaller periodic losses than passive “buy and hold” investors would experience in the stock market. This intent is not consistent with minimizing or avoiding every risk, particularly as valuations and expected return prospects improve.
I generally don't make much of the fact that nearly everything I have is invested in the Strategic Growth Fund and the Strategic Total Return Fund, but it may help to know that all of the decisions that affect the investments of my shareholders also directly affect my own investments. Given present market conditions, shareholders can be certain that I will continue to take an even-handed approach to both the risks and potential returns of the markets. As always, I am grateful for your trust.
As of last week, the Market Climate for stocks remained characterized by favorable valuations, and tentative market action – still unfavorable but with early evidence of improvement in market internals and pressures on risk premiums. As I noted last week, we are balancing the improvement in valuations and in some of our early measures of market action against our tolerance for risk. For that reason, we continue to have nearly all of our stock holdings defended with put option coverage. Part of that coverage is in-the-money, part is near-the-money, and part is out-of-the-money. This coverage will tend to mute our exposure to significant market losses, but not necessarily to small local movements of a few percent. In the event that the market declines significantly, we will gradually reduce the extent of our put option coverage as valuations improve further.
In bonds, the Market Climate last week was characterized by unfavorable yield levels and moderately favorable yield pressures. The wide credit spreads of recent months will almost certainly help to suppress inflation reports as the year continues. However, my impression is that the liquidation in commodities and inflation-protected securities overstates this inflation effect and instead reflects a great deal of forced selling on the part of hedge funds. Treasury Inflation Protected Securities have spiked to real yields of 3% and higher even at longer maturities.
Given the enormous expansion of government liabilities we are observing worldwide, it is unlikely that we will observe a long-term absence of inflation once the recent drop in monetary velocity abates. “Monetary velocity” declines when investors hoard government liabilities as safe havens – this suppresses inflation pressures by supporting the value of government liabilities, including currency. But velocity can also shoot higher once credit fears subside. So one of the casualties of easing credit fears is likely to be weakness in the U.S. dollar, and a concurrent strengthening in commodities – particularly precious metals, which serve as a currency substitute. Given the pricing of precious metals shares here, it would not be unexpected to see the XAU roughly double within the next 12 months from these levels.
The Strategic Total Return Fund moved the bulk of its assets from short-term Treasury securities to Treasury inflation protected securities as real yields on these securities surged well over 3%. We have avoided TIPS of short maturity that are selling at significant premiums to par. Despite their high real yields, the premiums over face value would erode in the event of deflation (though the securities do not mature at less than par in any event). The Fund also has about 30% of assets invested in securities outside of the fixed income area, primarily precious metals shares, foreign currencies, and utilities. We currently view all of these alternative assets as significantly undervalued here.
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