April 20, 2009
Over the past several weeks, the stock market has enjoyed a strong but low-sponsorship advance from deeply oversold conditions. Not surprisingly, this advance has prompted hope that the market is “looking over the valley” toward an economic recovery. This confusion between economic information and an oversold bounce is typical of strong bear-market rallies, as we saw during the 2000-2002 decline, as well as the surge off of the November lows. It immediately strikes me that investors don't understand that a near-term economic recovery would require a major and immediate resumption of the housing boom.
The current bounce was fueled by a combination of deteriorating but “less bad than expected” economic reports (therefore counting as “upside surprises”), as well as what can only be considered misleading and semi-fraudulent earnings reports from distressed financial companies (the CEOs of these companies should be careful, because Bernie Ebbers is their poster child). Overall, the picture looks a lot like the bounce we observed in May 2001 (just before unemployment shot up and the market plunged again to fresh lows), when I wrote:
“I've noted that most of the talk of having hit bottom in the economy is without support from the data. I have very little doubt that rather than having hit bottom, the economy is about to turn far uglier, far faster, than most analysts imagine. The economic outlook is increasingly bleak, but I have no opinion about how long investors will be able to look over the valley (or canyon) in hopes of a recovery.”
The market enjoyed another bear market rally a year later, well before the final lows. Again, the rally was coupled with hopes of a recovery, fueled by “upside surprises” in measures that were actually still very tepid. While the recession was in fact already over, that didn't stop the market from suffering a near-30% plunge to the final lows. Prior to the breakdown of that 2002 bear market rally, I noted:
“I really believe that most of the optimism about the economy boils down to two sets of data –Federal Reserve moves, and confidence surveys such as consumer confidence and the ISM Purchasing Managers Index. Early last year, I argued that Fed easings were likely to be ineffective in an investment-driven downturn, and nothing in the lending statistics has yet changed that view. The confidence surveys, of course, were wildly skewed by 9/11 - particularly because they generally ask whether the respondent feels that conditions are "better" than they were the month before. Who would not answer "yes" to that question with the post-9/11 shock as the frame of reference? The difficulty is that this recovery in sentiment is now fairly complete.”
In short, we should be careful to make distinctions between what constitutes improvement, and what only constitutes a backing off from extreme risk aversion. Put bluntly, the economy is not improving, and it is not likely to improve within a few months, because we have far more defaults, foreclosures, and credit excesses to work through. It is simply not true that the stock market heads higher 6 months before the economy bottoms. That simplification was true of 1970 and 1975, but not much else. Rather, there is enormous variation, and about the only reliable tendency is that stocks are usually advancing strongly within about 3 months of a recession's end. That said, in the 2000-2002 plunge, the market didn't bottom until about a year after the recovery started.
It is wishful thinking to believe that the stock market is forecasting the economy here just because we've observed a sharp advance off of an oversold trough. Yes, the stock market will probably bottom before the economy does, but lacking any credible approach to foreclosure abatement, the economic pain could easily extend well into 2010. We are likely to see a very wide and extended trading range, more deep selloffs, more short squeezes, and eventually disillusionment and revulsion from investors.
As the Wall Street Journal made clear in last Wednesday's front-page headline (“Banks Ramp Up Foreclosures”), much of the relief in the recent pace of the deterioration has been the result of “internal moratoriums which temporarily halted foreclosures.” The Journal also noted “the resulting increase in the supply of foreclosed homes could further depress home prices and put additional pressure on bank earnings as troubled loans are written off.”
As for the bank “earnings” that we observed last week, it is worth repeating that operating earnings exclude what happens on the balance sheet. Moreover, we've seen some really fascinating accounting distortions in these numbers. Witness Goldman Sachs' missing month of unreported losses. As the WSJ noted “ Goldman Sachs, for instance, announced earlier that it would change its fiscal year to end in December, unlike previous years when Goldman's year-end was in November. The move effectively eliminated a very ugly month from Goldman's official annual financial results for both 2008 and 2009.” As for Citigroup, the Journal reported Saturday that Citi's $1.6 billion reported earnings benefited from “a little-followed accounting adjustment under Financial Accounting Standards Board rule 159, which governs how banks value their debt” (note that this is separate from the FAS 157 “mark-to-market” provision). The effect of the adjustment was to boost Citigroup's earnings by $2.4 billion, because the value of its debt declined. So Citi reported earnings strictly because its bonds lost value. This would be funny if it was not so insidious.
Last week's issue of Barron's included an interview with William Black, who served as deputy director of the Federal Savings and Loan Insurance Corp. during the thrift crisis of the 1980s. That article included these clear-sighted comments on reality of the situation:
“We already know from the real costs -- through the cleanups of IndyMac, Bear Stearns, and Lehman -- that the losses will be roughly 50 to 80 cents on the dollar. The last thing we need is a further drain on our resources and subsidies by promoting this toxic-asset market. By promoting this notion of too-big-to-fail, we are allowing a pernicious influence to remain in Washington. The truth has a resonance to it. The folks know they are being lied to.
“With most of America's biggest banks insolvent, you have, in essence, a multitrillion dollar cover-up by publicly traded entities, which amounts to felony securities fraud on a massive scale. These firms will ultimately have to be forced into receivership, the management and boards stripped of office, title, and compensation. Right now, things don't look good. The government is reluctant to admit the depth of the problem, because to do so would force it to put some of America's biggest financial institutions into receivership. The people running these banks are some of the most well-connected in Washington, with easy access to legislators. Prompt corrective action is what is needed, and mandated in the law. And that is precisely what isn't happening. The savings-and-loan crisis showed that, too often, the regulators became too close to the industry, and run interference for friends by hiding the problems.
“We have lost the ability to be blunt. Now we have a situation where Treasury Secretary Geithner can speak of a $2 trillion hole in the banking system, at the same time all the major banks report they are well-capitalized. And you have seen no regulatory action against what amounts to a $2 trillion accounting fraud. The reason we don't see it -- aren't told about it -- is that if they were honest, prompt corrective action would kick in, and they would have to deal with the problem banks.”
Bear market rallies from oversold conditions are not predictable, in the sense that a market that has endured a steep selloff can easily continue lower another 10%-15% or more. Still, there has historically been some tendency – on average – for the market to rally off of deeply oversold conditions. The problem is that those generally positive averages mask an enormous amount of variation, so the actual return/risk ratio isn't nearly as attractive as one might imagine.
With the warning that the following figures do mask a very large amount of risk and variation, the charts below present the average percentage returns of the S&P 500 in the weeks following points when the index was at least 10%, 15%, 20%, 22%, and 25% below its 50-week smoothing. The 22% category is included because the sample size quickly becomes very small beyond that point. I've included two charts – one including data from 1940 through 2007, and the second including data from 2008. Note that the inclusion of 2008 makes an enormous difference, because the market simply failed to advance despite very deep compression – a reminder about the risk and variation within these averages.
Oversold bounces: Average cumulative S&P 500 % returns 1940-2007 based on starting % below 50-week smoothing (time scale measured in weeks):
Note that as we entered 2008, the historical record suggested that on average, an oversold condition taking the market at least 10% below its 50-week smoothing was followed over the next quarter by a positive average return of about 4%. Oversold conditions 15% or more below the 50-week smoothing were better, recovering about 7% of the loss over the following quarter, on average. However, deeper oversold conditions have historically demonstrated a tendency toward rapid gains for about 6 weeks, followed by a subsequent deterioration, on average, within a few percent of the prior lows.
Oversold bounces: Average cumulative S&P 500 % returns 1940-2008 based on starting % below 50-week smoothing:
Note that adding 2008 to the data set sharply reduces the average outcomes, though there is still a tendency for the market to rally a few percent off of an oversold condition for about 6 weeks. Rallies off of deeply oversold conditions display the same tendency to fade after about 6 weeks even after including 2008 to the set. Including the most recent advance to include all available data doesn't really help, because one would have bought the January low, which was followed by a steep failure.
I can't emphasize enough that there is a lot of variation here, but generally speaking, an investor who had never experienced 2008 might have some basis for say, owning some call options in response to a deeply oversold decline. The experience of 2008, coupled with the risk level inherent in such trades, substantially damaged the historical basis for that sort of strategy. Nonetheless, for separate risk-management reasons, we have generally carried about 1% of assets in index call options during the advance over the past 6 weeks, which has “softened” our hedge, and has compensated for our lack of holdings in distressed financials and homebuilders.
At present, the advance we've seen over the past several weeks is looking increasingly speculative. We certainly cannot rule out a further advance, but the basis for expecting one is currently weak. Better internals, higher quality leadership, broader sponsorship, and needless to say, a credible foreclosure abatement plan, would all be helpful "legs" if this advance is to be durable. For now, we don't observe enough of that evidence. Bill Hester has a nice research piece this week (Trading Volume Separates Bull Markets from Bear Rallies - additional link at the bottom of this comment) that expands on the concepts of "revulsion" and "sponsorship," and is a good companion piece to the analysis above.
It is important to remember that even failing rallies will often retreat by a few percent over several days, and suddenly recover the entire loss in a single session, with the recovery to the same or marginal new highs serving to make investors complacent when the real decline begins in earnest. Caution is still the order of the day.
As of last week, the Market Climate for stocks was characterized by mixed valuations – moderately favorable on measures that assume a sustained recovery to above-average profit margins, but overvalued on measures that assume normal historical profit margins in the future. Market action was also mixed, with generally good breadth as measured by advance-decline statistics, but a continued lack of sponsorship evident in trading volume. Much of the trading volume we've observed appears to be from relatively “high frequency” trading such as program trades and short-term mean reversion trading. That's not to say that we can't recruit more sponsorship for this advance, but at present, I am concerned by the combination of unimpressive sponsorship and an “economic recovery” play that I believe has vastly jumped the gun. The Strategic Growth Fund continues to be fully hedged, but with about 1% of assets in index call options, largely as a concession to observably good breadth despite an otherwise mixed profile of market action.
In bonds, the Market Climate remained characterized by moderately unfavorable yield levels and relatively neutral yield pressures. The Strategic Total Return Fund remained positioned largely in Treasury Inflation Protected Securities, with about 25% of assets allocated between precious metals shares, foreign currencies, and utility shares. The recent enthusiasm of investors about recovery prospects has coincided with a retreat in the demand for risk hedges such as precious metals. Meanwhile, the U.S. dollar has advanced somewhat, which has pressured gold a bit. Apart from those shorter-term dynamics, however, the U.S. dollar continues to be vulnerable in the face of massive monetization and the likelihood of a longer period of economic weakness than investors may be envisioning. Our overall investment position remains generally conservative, but is biased toward performing better in an environment of dollar weakness and pressure on U.S. real interest rates, which is consistent with the larger economic picture.
NEW from Bill Hester - Trading Volume Separates Bull Markets from Bear Rallies
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