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January 12, 2009

The Long-Term Gets Shorter

John P. Hussman, Ph.D.
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In recent months, I've emphasized that despite prospects for a prolonged recession which I would expect to keep the stock market in a very wide trading range (probably for the bulk of 2009), long-term investors should not overlook the sea-change in valuations and security durations we've observed over the past 15 months.

For someone who has been labeled both a “perma-bear” over the past decade, as well as a “one lonely raging bull” in the early 1990's (Los Angeles Times), I can't say that either description is fitting at the moment. What seems clear, however, is that with the steep losses in the stock market in recent quarters, the utterly dismal long-term return prospects that have weighed this market down for the past 12 years are largely behind us (the S&P 500 has turned in a total return of just 3.4% annually over that period).

Valuations are improved, but there is an overhang of continuing economic difficulty that will probably require more writedowns, restructurings, and displacements. I expect that process to grind along, but with an ebb-and-flow of both positive and negative surprises. It is hard to expect stocks to launch into a sustained bull market anytime soon (we should rule out neither a sharp short squeeze nor a retest of last year's lows), but improved valuations, coupled with a retreat in credit spreads, suggest that we may not require white-knuckle, fully-hedged investment positions for a while.

In last week's market comment, I emphasized the shift in durations that we've observed in recent quarters, with stock durations plunging and bond durations getting much longer. The February 23, 2004 comment (Buy and Hold for the Duration?) contains an analytical discussion of duration and its importance, but the simple point here is that the longer the duration of an investment, the longer the investment horizon a passive investor requires in order to expect a reasonably predictable long-term return.

A simple example of duration is a 10-year zero-coupon bond, which simply has a duration of 10 years. Absent default risks, an investor having a 10-year horizon can be certain of the long-term return that will be achieved on that investment, regardless of where the price of the bond goes in the interim. A 10-year bond with a 10% coupon, however, only has a duration of about 6.75 years. The reason for the shorter duration is that the investor is actually receiving some of the cash flow from their investment well in advance of the maturity of the bond itself, and those coupon payments can be reinvested as prices change. The shorter duration of the bond effectively shortens the investment horizon that is required to “immunize” the investor's terminal wealth (though not necessarily year-to-year values) from market fluctuations.

To give you some idea of the magnitude of the duration shifts we've observed lately, the following chart presents the duration (in years) of investments in the S&P 500 and 10-year bonds. I've placed them on separate scales since the duration of 10-year bonds is smaller, and has much less volatility than the duration of stocks.

It should be clear that the run to the 2000 stock market peak represented terribly careless investor behavior, as the S&P 500 was driven to a duration over over 90 years. That is, only an investor with a horizon of 90-years could be confident that the terminal value of their investment would not be sensitive to the fluctuations in the market over the course of that holding period. In contrast, an investor with a 5, 10, or 20 year horizon was entirely at the mercy of market direction.

In contrast, look at 1982. At that time, the 10-year Treasury bond had a duration of just 6 years (due to the very high coupon payments and yield-to-maturity available), while the S&P 500 had an extraordinarily low duration of just 16 years. Given those durations, an investor with 15-20 years to invest could literally plow their entire portfolio into stocks and long-term bonds, in expectation of very high long-term returns, with the additional comfort that their financial security did not rely on the direction of the markets, thanks to the ability to reinvest generous coupon payments and dividends.

Presently, the duration of stocks has fallen to about one-third of what it was in 2000. Stock durations aren't particularly low on a historical basis, but are out of the range that I've considered ridiculously dangerous since the late 1990's. In contrast, bond durations as of the end of 2008 were higher than at any time since the early 1950's, so that an investor in 10-30 year Treasury bonds is presently assured of a low yield-to-maturity if the bond is held for the long-term, while being at the mercy of market direction even to achieve that low rate of return.

As usual, investors hoping for an “annual forecast” for 2009 will have to find it elsewhere, since our investment positions focus on prevailing conditions of valuation and market action, and we shift our stance as the evidence changes. As my friend Thich Nhat Hanh says, if we take good care of the present, we will take good care of the future. My general sense is that stock valuations are reasonable, though not deeply undervalued, and risk premiums are abating given that the economy appears to have pulled back from the brink of large-scale bank failures. Still, the transition to an economy that is less dependent on leverage will be a difficult one. John Mauldin has frequently used the term “muddle through” to describe the behavior of the economy since 2000. That's probably a reasonable expectation for 2009 as well.

Market Climate

As of last week, the Market Climate for stocks was characterized by favorable valuations and relatively neutral market action. Market action is somewhat sensitive here, in that an improvement in market internals over the near term could trigger some short covering, and possibly some amount of demand on improved confidence that the worst-case scenario for the economy has been avoided. At the same time, we don't yet have enough evidence of robust improvement in risk preferences, so a deterioration in market action would erode some of the basis for the constructive “local” exposure that we are carrying.

For now, the Strategic Growth Fund remains largely hedged against deep, significant market losses, but remains reasonably exposed to “local” fluctuations. Our current hedge places our line of defense between the 800 and 900 area on the S&P 500 for now, meaning that our sensitivity to market fluctuations begins to mute on market weakness below about 900, and would strongly mute if the S&P 500 approaches 800 or lower. As always, the extent and structure of our hedging will shift as market conditions change.

In bonds, the Market Climate last week was characterized by unusually unfavorable yield levels and relatively favorable yield pressures. The compressed yield levels and low durations in the long-term Treasury market continue to be a cause of major concern, and we are presently avoiding straight long-term Treasury securities in the Strategic Total Return Fund. The Fund currently holds primarily Treasury Inflation Protected Securities (which currently price in expectations of zero inflation for the next decade or more, while reflecting reasonably high inflation-adjusted yields to maturity). We continue to carry about 10% of assets in precious metals shares, about 5% in utility shares, and about 10% of assets in foreign currencies.

New from Bill Hester: Will Global Markets Take Their Lead from the U.S.?

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